Documente Academic
Documente Profesional
Documente Cultură
AND THE
FINANCING DECISION
Net Working Capital – is the excess of current assets over current liabilities
Working Capital Management – involves the determination of the level, quality and
maturity of each major current asset and current liability. It also refers to the
administration and control of current assets and current liabilities to insure that they
are adequate and used effectively for business purposes.
Working capital management involves the financing and management of the current
assets of the firm. The amount by which current assets exceed current liabilities in
financial management for two important reasons:
1
Although current assets are turned over within relatively short periods, they always
represent some percentage of sales. In this sense, a portion of current assets must be
owned by the firm permanently. Consequently, it is appropriate that a portion of
current assets be financed permanent sources.
1. What is the appropriate level for current assets, both in total and by specific
accounts? and
2. How should current assets be financed?
1. Business failure.
2. The company may not able to pursue its objectives because of lack of funds.
2
ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES
- A policy where a large amount of cash, marketable securities, and inventories are
carried and under which sales are stimulated by a liberal credit policy, resulting
in a high level of receivables.
- This policy provides the lowest expected return of investment because capital tied
up in current assets either does not earn any substantial income at all or a
minimal income if any, but it entails lower risk.
- This approach uses permanent or long-term financing source to finance all
permanent assets and also part of the temporary current assets and then hold
temporary surplus funds as marketable securities as the trough of the cycle.
- Here, the amount of permanent or long-term capital exceeds the level of
permanent assets.
- The policy is called for the least use of short-term debt.
- It offers the lowest expected return but also the lowest risk
- In this firm, the firm has fewer liquid assets with which to prevent a possible
financial failure.
- Holdings in cash securities, investors and receivables are minimized.
- While Risk of financial failure is high because the small amount of total capital
commitment, the profitability rate is measured by the rate of return as total
assets however is high.
- In this approach, a firm finances all of its fixed assets with long-term capital but
part of its permanent current assets is financed with short-term, no spontaneous
credit. This happens because to acquire long-term funds, the firm must generally
go to the capital markets with a stock or bond offering or must negotiate long-
term obligations with insurance companies, and so on.
- Many small businesses do not have access to such long-term capital; thus, a
relatively highly aggressive firm would be very much subject to dangers from
using interest rates as well as to loan renewal problems.
- Although short-term debt is often cheaper than long-term debts, some firms are
willing to sacrifice safety for the chance of higher profits.
- It is called for the greatest use of short-term debt.
- It has the highest expected rate of return, but short-term financing brings it with
the greatest risk
3
3. Moderate Current Assets Investment Policy
In the equations, long term funds are matched to long term assets and vice versa.
4
a. Permanent Assets Financed with Short Term Financing: In this
situation, the borrower has to renew or refinance the short term loan every
time simply because the duration for which money is required is higher, say 3
years, than the available loan is of, say 6 months only. The firm needs to
renew the loan 6 times. This firm is exposed to refinancing risk.
If the lender for any reason denies for renewal, what will the firm do? In such
a situation for paying off the loan, either the firm will sell the permanent
assets which effectively means closing the business or file for bankruptcy.
After all the discussion, in situation A, we learned that costs may be low but
the risk is too high and situation B concludes high with low risk. Situation A
is not acceptable because of such a high risk and situation B hits the profitability
which is the primary goal of doing business and basis of survival. Therefore, the
hedging or matching maturity approach to finance is ideal for effective working
capital management.
5
only for the amount and time for which money is used. There is no unutilized
cash lying idle with the business.
Risks Still Persist: After adopting this strategy and planning everything in
accordance with it, if the assets are not realized on time, it will not be possible to
extend the loan due dates unreasonably. In that situation, the strategy moves
either towards conservative or aggressive approach. Once that happens, the
analytics and risks of those strategies will apply. The risks which are avoided with
this strategy again come into play.
2. Aggressive Approach
– is a high-risk strategy of working capital financing wherein short-term finances
are utilized not only to finance the temporary working capital but also a
reasonable part of the permanent working capital. In this approach of financing,
the levels of inventory, accounts receivables and bank balances are just sufficient
with no cushion for uncertainty. There is a reasonable dependence on the trade
credit.
6
Financing Strategy in Equation:
Lower Carrying and Handling Cost: Lower level of inventory makes the
carrying and holding cost also go down and that directly affect the profitability.
Insolvency Risk: This strategy faces the high level of insolvency risk because
the permanent assets are financed by the short-term financing sources. To
maintain those permanent assets, the firm would need to be repeated refinancing
and renewals. It is not necessary that all the time the refinancing is smooth. For
any reason, if the financial institution rejects the renewal, the firm will not be in a
position to maintain those permanent assets and will have to forcibly sell them. If
failed in realizing those assets, the options left is liquidation. Liquidating the
permanent working capital is very difficult as it consists of accounts receivables
and inventory.
7
3. Conservative Approach
– is a risk-free strategy of working capital financing. A company adopting this
strategy maintains a higher level of current assets and therefore higher working
capital also. The major part of the working capital is financed by the long-term
sources of funds such as equity, debentures, term loans etc. So, the risk
associated with short-term financing is abolished to a great extent. In the
conservative approach, fixed assets, permanent working capital and a part of
temporary working capital is financed by long-term financing sources and the
remaining part only is financed by short-term financing sources.
Higher Interest Cost: This strategy employs long-term sources of finance and
hence there are all the chances that the rate of interest will be high. The theory of
term premium says that the long-term funds have higher interest rate compared
8
to short-term funds as risk perception and uncertainty is high in case of longer
terms.
Idle Funds: Long term loans cannot be paid off when wished and if paid cannot
be easily availed back. As we noted in the diagram, the long-term funds remain
unutilised in the times when seasonal spurt in activity is not there. Idle funds
have an opportunity cost of interest attached to it.
Higher Carrying Cost: A Higher level of inventory and debtors implies higher
carrying and holding cost which has a direct impact on profitability.
9
We will compare these three approaches on 6 parameters viz. liquidity, profitability, risk, asset utilization, and working capital.