A Quick Introduction to Finance, Part I

A recent article over on CPO Agenda on Skills for the Future that summarized the findings from a recent workshop that debated the skills the future would require identified better finance skills as keys to future purchasing success. Since the article simply rambled off a list of terms with no definition, I decided I’d define the basics for you.

Working Capital: is a financial metric which represents the operating liquidity available to a business. It’s calculated as current assets minus current liabilities. Positive working capital is required to ensure that a firm is able to continue its operations. Furthermore, it must have enough cash on hand to satisfy operational expenses and maturing debt.

Current Assets: include inventory, holdings, and accounts receivable.

Current Liabilities: accounts payable, debts, and (due) operational expenses.

A key part of working capital management is:

Cash Management: which aims to ensure that the business always has enough cash-on-hand to meet day-to-day expenses.

For example, let’s say that monthly payroll is 200,000, monthly leases are 50,000, and 100,000 in payables are due within the next 30 days. This says that the business needs 350,000 to meet its expenses this month. This also says that, unless payables are received, if the business only has 400,000 in the bank, then it only has 50,000 available for new investments or initiative. As a result, even if you wanted to buy 100,000 in raw materials to negate the need for your supplier to get financing and reduce total supply chain costs, you couldn’t do so. On the other hand, if the business had 500,000 in the bank, you could, but you wouldn’t necessarily want to unless it was the best use of the business’ cash.

Part of Working Capital Management is making the right decisions when it comes to managing cash. This includes making the right borrowing decisions as well as the right investing decisions. If financing your supplier reduced your total cost of ownership of 300,000 worth of goods by 1%, but a short term loan could generate 6% interest, the short term loan would be the better decision. This is because it would generate 0.06 * 100K or 6K worth of interest as opposed to the 0.01 * 300K or 3K worth of savings. On the other hand, if the financing reduced the total cost of ownership of the goods by 3% and the best interest rate was only 4%, financing the supplier’s raw material buy would be the right choice because 9K worth of savings beats 4K worth of interest any day. This is the type of financial planning that Supply Management professionals need to understand to make the right recommendations, and decisions, for the business as a whole.

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