Firms: Definition in Business, How They Work, and Types

What Is a Firm?

A firm is a for-profit business organization—such as a corporation, limited liability company (LLC), or partnership—that provides professional services. Most firms have just one location. However, a business firm consists of one or more physical establishments, in which all fall under the same ownership and use the same employer identification number (EIN).

When used in a title, "firm" is typically associated with businesses that provide professional law and accounting services, but the term may be used for a wide variety of businesses, including finance, consulting, marketing, and graphic design firms, among others.

Theory of the Firm

In microeconomics, the theory of the firm attempts to explain why firms exist, why they operate and produce as they do, and how they are structured. The theory of the firm asserts that firms exist to maximize profits; however, this theory changes as the economic marketplace changes. More modern theories would distinguish between firms that work toward long-term sustainability and those that aim to produce high levels of profit in a short time.

Firm vs. Company

Although they appear synonymous and are often used interchangeably, there is a difference between a firm and a company. A company can be any trade or business in which goods or services are sold to produce income. Further, it encompasses all business structures, such as a sole proprietorship, partnership, and corporation. On the other hand, a firm typically excludes the sole proprietorship business; it generally refers to a for-profit business managed by two or more partners providing professional services, such as a law firm. In some cases, a firm can be a corporation.

Types of Firms

A firm's business activities are typically conducted under the firm's name, but the degree of legal protection—for employees or owners—depends on the type of ownership structure under which the firm was created. Some organization types, such as corporations, provide more legal protection than others. There exists the concept of the mature firm that has been firmly established. Firms can assume many different types based on their ownership structures:

• A sole proprietorship or sole trader is owned by one person, who is liable for all costs and obligations, and owns all assets. Although not common under the firm umbrella, there exists some sole proprietorship businesses that operate as firms.
• A partnership is a business owned by two or more people; there is no limit to the number of partners that can have a stake in ownership. A partnership's owners each are liable for all business obligations, and together they own everything that belongs to the business.
• In a corporation, the businesses' financials are separate from the owners' financials. Owners of a corporation are not liable for any costs, lawsuits, or other obligations of the business. A corporation may be owned by individuals or by a government. Though business entities, corporations can function similarly to individuals. For example, they may take out loans, enter into contract agreements, and pay taxes. A firm that is owned by multiple people is often called a company.
• A financial cooperative is similar to a corporation in that its owners have limited liability, with the difference that its investors have a say in the company's operations.

Resources Used by Firms

The objective of a firm to is convert inputs into outputs. For this reason, firms use a variety of resources to generate products, services, and offerings to clients. These resources may include but aren't limited to:

• Natural resources. If a firm sells products, they often utilize natural resources to build the goods and inventory to eventually convert to a finished product. These resources may be directly sourced, though may also be acquired from a third-party.
• Capital resources. Firms often need upfront investment to buy the required equipment and space needed to function. There may also be ongoing capital needs prior to the firm being self-sustaining. These capital resources may be from external investors, though the long-term goal is to have these capital resources be generated by firm operations.
• Human resources. The employees of a firm are the lynchpin that ensures the underlying business can operate. People's time, expertise, and networks are all resources that go into a firm to further enhance market offerings. Human resources often reference a specific department, but people resources exist throughout a company in all departments.
• Entrepreneurship. Entrepreneurship is the utilization of knowledge, expertise, and business sense to translate an idea into a financially successful operation. This includes using business, legal, and entrepreneurial resources to successfully bring a product to market and ensure the offering is well-received by markets.

Activities of a Firm

The activities of a firm can often be broken down into three categories: business operating activities, investing activities, and financing activities. These three categories are listed on a firm's statement of cash flow and are discussed further below.

Business Operating Activities

The primary activity of a company (and the primary section on a statement of cash flow) is the operating activities section. This section ties to the actual core business of the company. These activities include selling products or incurring business expenses. Most of these activities are related to the income statement, as these activities most often relate to a company's day-to-day operations and income.

In some cases, the operating activities section of a statement of cash flow is negative. If the amount is negative, that means the company is using/spending more cash than it is bringing in specific to business operations. This also means the company must rely on the other two sections to ensure enough cashflow is coming into the company to maintain operations.

Investing Activities

Investing activities are the long-term cashflow activities a company incurs to plan for the future and ensure it has the infrastructure to scale operations. Examples of investing activities include acquiring equipment, constructing office buildings, or buying heavy equipment.

Although these activities may not be required for day-to-day operations, investing activities play an integral part in a firm's long-term success. Consider a firm that makes its own goods. By investing in a corporate warehouse and robust manufacturing plant, the firm is more likely to achieve business operation success.

Financing Activities

The last section of activities of a firm are the financing activities. Although these are also not usually part of the day-to-day operations of a firm, the financing activities play an important in ensuring the long-term financial health of a firm.

Some financing activities are cash inflows, while other are cash outflows. For example, firms may decide to award dividends to investors funded from net income of the firm. Alternatively, firms may borrow money from lenders or issue equity to investors to raise capital to support the day-to-day operations.

The Bottom Line

A firm often refers to a company that sells a service to customers, though sometimes a physical good may be transmitted as well. The ultimate goal of a firm is to make money, as a firm is often not a non-profit. The activities of a firm can usually be broken into the operating, investing, and financing aspects of the firm.