A company's revenue affects various working capital accounts, which include inventory, accounts receivable and accounts payable. Revenue increases may have a positive or negative effect on working capital accounts depending on how quickly the company converts sales into cash or current assets to support its current liabilities.
Working capital is equal to current assets less current liabilities. A company with positive working capital has enough short-term assets to pay off its current liabilities. A company with a negative working capital position cannot meet its short-term obligations with its current assets. Working capital ratios measure management's operating efficiency. Two ratios that utilize working capital accounts include the current ratio (current assets / current liabilities) and quick ratio ([current assets minus inventories] / current liabilities). A ratio greater than 1 is a good indication of the company's ability to manage short-term financial obligations.
The point in time when a company records a sale impacts its working capital accounts. For example, a company records a sale and funds from the sale immediately in an all-cash business. However, in many instances, revenue recognition does not lead to an immediate influx of cash but rather an accounts receivable, which is a short-term asset.
Working Capital Management
In general, increases in revenue lead to higher accounts receivables, depleting inventories, and possibly higher accounts payable. As the company sells more products, it uses its available inventory. Increases and decreases in accounts payable relate how the company uses short-term financing to fund its operations. An increase in accounts payable indicates company use of vendor financing to finance ongoing operations. Ideally, as the company collects money from its accounts receivable, it uses the proceeds to pay down accounts payable.
Merely looking at the effects of increasing or decreasing revenue on working capital is not enough. An analyst must dig deeper into the individual accounts to discover the physical makeup of working capital, which is an indication of the financial health and strength of the company. For example, even though inventory is a current asset, it may be of low quality. Higher inventory level coupled with a declining sales rate may be an indication of outdated inventory. The company may have to offer discounts to customers to rid itself of unwanted merchandise, which puts a squeeze on profit margins. In addition, higher levels of accounts payable coupled with lower levels of accounts receivable is a sign that the company is too reliant on vendor financing or is unable to pay vendors on time. Higher receivables may be an indication that the company is having trouble collecting from its customers.
How to Use the GAAP Allowance Method
No matter how careful any business is in extending credit, there will always be some customers that will not pay their bills....
Capital Expenditure Vs. Revenue Expenditure
Capital expenditures are assets that are acquired to expand business capacity to earn or produce. Costs that are attributed to maintaining earnings...
Useful Financial Tools for Working Capital Management
Working capital is defined as the total current assets, cash, receivables and inventory of a company, minus its current liabilities, which are...
How to Analyze Working Capital Management
Manage and track your inventory. Inventory consists of raw material, work in progress and finished goods.Key things to remember in managing your...
The Effects of a Decrease in Tax Rates on Revenues
Governments raise revenue through taxation and by charging for services. The majority of revenue, however, comes from taxes. Economists are divided on...
Why Would My Credit Score Go Down?
Because your credit score affects your ability to obtain credit and the interest rate you will pay on new credit accounts, it...
Difference Between Capital & Revenue Expenditure
Accounting is a business function where companies record transactions relating to their operations. Accounting rules require companies to follow specific standards ...