Working capital Investment policy (Financial Management)

1. Investment policy and working capital

2. • Working capital requirement

• Investment policy and working capital financing
• Explain the advantages and disadvantages of short-term credit

3. FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

• Nature of business
• Seasonality of operations
• Production policy
• Market conditions
• Conditions of supply

4. FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

Nature of Business
• The working capital requirements of a firm are closely related to the nature of its business.
• A service firm, like an electricity undertaking or a transport corporation, which has a short operating
cycle and which sells on cash basis, has modest working capital requirements.
• On the other hand, a manufacturing concern like a machine tools unit, which has a long operating
cycle and which sells on credit, has very substantial working capital requirements.

5. Nature of Business
•Short operating cycle – cash – modest WC
•Long operating cycle – credit – substantial WC

6. Exhibit shows the relative proportions of investment in current assets and fixed assets for certain
industries

7. FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

Seasonality of Operations
• Firms which have seasonality in their operations usually have highly fluctuating working capital
requirements
• Consider firm manufacturing ceiling fans. The sale of ceiling fans reaches a peak during summer and
drops sharply during winter.
• The working capital requirements of such a firm are likely to increase in summer and decrease
significantly during winter.
• On the other hand, a firm manufacturing a product like lamps, which have fairly even sales round the
year, tends to have stable working capital requirements.

8. Seasonality of Operations
•Peak season – high demand – high WC
•Low season – low demand – low WC

9. FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS Production Policy

• A firm marked by seasonal fluctuations in its sales may pursue a production policy which may reduce
variations in working capital requirements.
• For example, a manufacturer of ceiling fans may maintain a steady production throughout the year,
rather than intensify the production activity during the peak business season.
• Such a production policy may reduce the fluctuations in working capital requirements.

10. FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS Market Conditions

• The degree of competition in the market is important for working capital needs.
• When competition is strong, a larger inventory of finished goods is required to promptly serve
customers who may not be motivated to wait because other manufacturers are ready to meet their
needs.
• Further, generous credit terms may have to be offered to attract customers in a highly competitive
market.
• Thus, working capital requirements tend to be high because of greater investment in finished goods
inventory and accounts receivable.
• If the market is strong and competition weak, a firm can manage with a smaller inventory of finished
goods because customers can be served with some delay.
• Further, in such a situation the firm can insist on cash payment and avoid lock-up of funds in accounts
receivable—it can even ask for advance payment, partial or total.

11. Market Conditions

•Strong competition – credit – quick sales – high WC
•Weak competition – cash – delayed sales – low WC

12. FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

Conditions of Supply
• The inventory of raw materials depends on the conditions of supply.
• If the supply is quick, the firm can manage with small inventory.
• However, if the supply is unpredictable, then the firm, to ensure continuity of production, would have
to carry larger inventory.
• A similar policy may have to be followed when the raw material is available only seasonally and
production operations are carried out round the year

13. Conditions of Supply

•Quick supply – small inventory
•Unpredictable supply – large inventory

14. Level of investment in current assets – or WC investment policy

• Conservative Moderate Aggressive
• Ica ↑ Ica ↓
• CF ↑ CF ↓
• Inventory ↑ Inventory ↓
• Credit ↑ Credit ↓
• Delivery ↑ Delivery ↓
• Sales ↑ Sales ↓ HIGH WC LOW WC

15. LEVEL OF INVESTMENT IN CURRENT ASSETS

Conservative policy
• Under a flexible policy (also referred to as a 'conservative policy'), the investment in current assets is
high.
• This means that the firm maintains a huge balance of cash and marketable securities, carries large
amounts of inventories, and grants generous terms of credit to customers which leads to a high level of
debtors.

16. LEVEL OF INVESTMENT IN CURRENT ASSETS

Aggressive policy
• Under a restrictive policy (also referred to as an 'aggressive policy'), the investment in current assets is
low.
• This means that the firm keeps a small balance of cash and marketable securities, manages with small
amounts of inventories, and offers stiff terms of credit which leads to a low level of debtors.

17. LEVEL OF INVESTMENT IN CURRENT ASSETS

Moderate policy
• A moderate policy would tread a middle path between the aggressive and conservative approaches.
• It should be noted that the working capital policies of a company can be characterized as aggressive,
moderate or conservative only by comparing them with the working capital policies of similar
companies.

18. LEVEL OF INVESTMENT IN CURRENT ASSETS

• What are the consequences of flexible and restrictive policies?
• A flexible policy results in fewer production stoppages, ensures quick deliveries to customers, and
stimulates sales because liberal credit is granted to customers. Of course, these benefits come at the cost
of higher investment in current assets.
• A restrictive policy, on the other hand, may lead to frequent production stoppages, delayed deliveries
to customers, and loss of sales. These are the costs that the firm may have to bear to keep its investment
in current assets low.

19. CURRENT ASSETS FINANCING POLICY

• After establishing the level of current assets, the firm must determine how these should be financed.
• What mix of long-term capital and short-term debt should the firm employ to support its current
assets?

20. CURRENT ASSETS FINANCING POLICY

Strategies
• Strategy A: Long-term financing is used to meet fixed asset requirements as well as peak working
capital requirements. When the working capital requirement is less than its peak level, the surplus is
invested in liquid assets (cash and marketable securities).
• Strategy B: Long-term financing is used to meet fixed asset requirements, permanent working capital
requirements, and a portion of fluctuating working capital requirements. During seasonal upswings,
short-term financing is used; during seasonal downswings, surplus is invested in liquid assets.
• Strategy C: Long-term financing is used to meet fixed asset requirements and permanent working
capital requirements. Short-term financing is used to meet fluctuating working capital requirements.

21. CURRENT ASSETS FINANCING POLICY

• Exhibit depicts how total assets - and hence the capital requirements - change over time for a growing
firm.
• For simplicity, assets are divided into two classes, fixed assets and current assets.
• Fixed assets are assumed to grow at a constant rate which reflects the secular rate of growth in sales. •
Current assets, too, are expected to display the same long term rate of growth; however, they exhibit
substantial variation around the trend line, thanks to seasonal (or even cyclical) patterns in sales and/or
purchases.
• The investment in current assets may be broken into two parts: permanent current assets and
temporary current assets. The former represents what the firm requires even at the bottom of its sales
cycle; the latter reflects a variable component that moves in line with seasonal fluctuations.
• Several strategies are available to a firm for financing its capital requirements. Three strategies are
illustrated by lines A, B, and C in Exhibit.

22. CURRENT ASSETS FINANCING POLICY

• Assets are divided into two classes: fixed assets and current assets CA
• The investment in CA may be broken into two parts: permanent CA and temporary (fluctuating) CA

23. CA financing policy – or WC funding policy

Conservative
• Fixed assets and permanent CA – supported by long-term sources of finance
• fluctuating CA - supported by long-term sources of finance
Moderate policy
• Matching principle:
• Fixed assets and permanent CA – supported by long-term sources of finance
• fluctuating CA - supported by short-term sources of finance
Aggressive
• Permanent CA – supported by short -term sources of finance
• fluctuating CA - supported by short-term sources of finance

CURRENT ASSETS FINANCING POLICY

24. The Matching Principle
• Related to Moderate policy:
• According to this principle, the maturity of the sources of financing should match the maturity of the
assets being financed.
• This means that fixed assets and permanent current assets should be supported by long-term sources
of finance, whereas fluctuating current assets must be supported by short-term sources of finance.
• Strategy C in Exhibit reflects the matching principle.

25. The Matching Principle

• A conservative funding policy uses long-term funds to finance not only fixed assets and permanent
current assets, but some fluctuating current assets as well.
• As there is less reliance on short-term funding, the risk of such a policy is lower, but the higher cost of
long-term finance means that profitability is reduced as well.

CURRENT ASSETS FINANCING POLICY

26. The Matching Principle
• An aggressive funding policy uses short-term funds to finance not only fluctuating current assets, but
some permanent current assets as well.
• This policy carries the greatest risk to solvency, but also offers the highest profitability and increases
shareholder value.
CURRENT ASSETS FINANCING POLICY
27. The Matching Principle
• The rationale for the matching principle is straightforward.
• If a firm finances a long term asset (say, machinery) with a short- term debt (say, commercial paper), it
will have to periodically re- finance the asset.
• Whenever the short-term debt falls due, the firm has to refinance the assets.
• This is risky as well as inconvenient.
• Hence, it makes sense to ensure that the maturity of the assets and the sources of financing are
properly matched.

CURRENT ASSETS FINANCING POLICY

The Matching Principle
28. Short-term finance
• Short-term sources of finance include:
• Overdrafts
• Short-term bank loans
• Trade credit

29. Short-term finance

Overdraft
• Agreement to borrow
• Flexible
Short-term loan
• fixed borrowing with interest payment
• Less flexible
Trade credit
• Agreement to pay later
• Major source of finance

30. Short-term finance – overdraft

• An overdraft is an agreement by a bank to allow a company to borrow up to a certain limit without the
need for further discussion.
• The company will borrow as much or as little as it needs up to the overdraft limit and the bank will
charge daily interest at a variable rate on the debt outstanding.
• The bank may also require security or collateral as protection against the risk of non-payment by the
company.
• An overdraft is a flexible source of finance in that a company only uses it when the need arises.
• However, an overdraft is technically repayable on demand, even though a bank is likely in practice to
give warning of its intention to withdraw agreed overdraft facilities.

31. Short-term finance - short-term loan

• A short-term loan is a fixed amount of debt finance borrowed by a company from a bank, with
repayment to be made in the near future, for example after one year.
• The company pays interest on the loan at either a fixed or a floating (i.e. variable) rate at regular
intervals, for example quarterly.
• A short-term bank loan is less flexible than an overdraft, since the full amount of the loan must be
borrowed over the loan period and the company takes on the commitment to pay interest on this
amount, whereas with an overdraft interest is only paid on the amount borrowed, not on the agreed
overdraft limit.
• As with an overdraft, however, security may be required as a condition of the short-term loan being
granted.

32. Short-term finance - Trade credit

• Trade credit is an agreement to take payment for goods and services at a later date than that on which
the goods and services are supplied to the consuming company.
• It is common to find one, two or even three months’ credit being offered on commercial transactions
and trade credit is a major source of short-term finance for most companies.

33. Short-term finance

• Short-term sources of finance are usually cheaper and more flexible than long-term ones.
• Short-term interest rates are usually lower than long-term interest rates, for example, and an overdraft
is more flexible than a long-term loan on which a company is committed to pay fixed amounts of interest
every year.
• However, short-term sources of finance are riskier than long-term sources from the borrower’s point of
view in that they may not be renewed (an overdraft is, after all, repayable on demand) or may be
renewed on less favorable terms (e.g. when short-term interest rates have increased).