• Lenders prefer a company having a large excess of current assets over current liabilities whereas the owners prefer a high return.
• Current assets have the advantage of being liquid, but holding them is not very profitable. • Cash account is paid no interest.
• Accounts receivable earns no return. • Inventory earns no return until it is sold.
• Non-current assets can be profitable, but they are usually not very liquid.
• Firms are usually faced with creating trade-off in their working capital management policy. • They seek a balance between liquidity and profitability that reflects their desire for profit and their
need for liquidity.
OPTIMAL LEVEL OF CURRENT ASSETS
A firm’s optimal level of current assets is reached when the optimal level of cash, inventory, accounts receivable, and other current assets is achieved.
Cash: firms try to keep just enough cash on hand to conduct day-to-day business, while investing extra amounts in short-term marketable securities.
Inventory: firms seek the level that reduces lost sales due to lack of inventory, while at the same time holding down bad debt and collection expenses through sound credit policies.
• PROJECTING THE ALL THREE POLICIES
• CONSERVATIVE = A • MODERATE = B • AGGRESSIVE = C
A
A
C
LOW
B
B
B
NOR
C
C
A
HIGH
RISK PROFITABILITY LIQUIDITYThechart tells us two things:
- Profitability varies inversely with liquidity; increased liquidity can be achieved at the expense of
(decreased) profitability
- Profitability & risk have same direction; in order to have greater profitability, we need to take
greater risk.
- Conclusion: optimal level of each current asset will depend on the management’s attitude
towards risk & return.
Risk and Return of Current Liabilities
The goal of the return management process is to maximize earnings in the context of an acceptable level of risk.
Firm’s working capital is financed from short-term borrowing, long-term borrowing, equity financing, or some mixture of all three.
The choice of the firm’s working capital financing depends on manager’s desire for profit versus their degree of risk aversion.
The balance between the risk and return of financing options depends on the firm, its financial managers, and its financing approaches.
Corporate Finance –FIN 622 VU
Lesson 27 WORKING CAPITAL MANAGEMENTThe following topics will be discussed in this lecture.
Classification of working capital
Current Assets Financing – Hedging approach
Short term Vs long term financing
Risk of short & long term financing
Trade off of short & long term financing
¾ Classifications of Working Capital
Working capital or current assets can be classified according to - Components: like inventory, cash, securities, receivables - Time basis: it may be temporary or permanent.
Temporary working capital is the amount of investment in current assets that varies according to the seasonal requirements. For example, consider an ice cream manufacturing firm. During the months of May – September the manufacturer has to keep the maximum inventory to support high level sales. During off- season like from November to January the sales are extremely low and lower investment in inventory is required. Now consider if a festival like Eid or Christmas is falling during December and this would result in high sales, then a temporary increase in inventory would be required to support this sale level.
Permanent working capital is the minimum investment in current assets that is required support long-term minimum need. Permanent working capital resembles to fixed assets in two aspects. First the dollar investment is long term despite contradiction that assets being financed are called ‘current’. Second, for a growing firm, the need to increase the minimum permanent working capital is the same as of fixed assets. However, there is a case of difference between the permanent working capital and fixed asset – that is the later always changing constantly.
Like permanent working capital, temporary working capital also comprises of current assets in a constantly changing form. However, because the need for this part of the firm’s total current assets is seasonal, we want to consider financing this level of current assets from a source which can itself be seasonal or temporary in nature. In the next section we pick up the problem of how to finance current assets.
¾ Short Term & Long Term Mix
Investment in current asset does involve a trade off between the risk and profitability. As a matter of fact the current liabilities side of working capital does not consist of active decision variables in the sense; you cannot defer payment to creditors beyond certain limits. Same is true for accrued expenses like electricity, payroll etc. There’s no big room for playing with current liabilities which are also termed as spontaneous source of finance. As the underlying investment in current assets grows, accounts payable and accruals also tend to grow, in part financing the increase in assets. The issue here is how to handle assets not supported by spontaneous financing. This is termed as residual financing requirements – that is net investment after deducting spontaneous financing.
¾ Current Assets Financing – Hedging Approach
Under this approach each asset would be offset with a financing instrument of the same maturity. Short term seasonal investment requirements should be financed through short term loans and permanent current asset and all fixed assets should be financed through long term loan and equity. This can be illustrated from the following figure:
Corporate Finance –FIN 622 VU
NON CURRENT ASSETS
LONG TERM LOANS PERMANENT CA
TEMPORARY CA
SHORT TERM LOANS
TIME IN V E ST M E N T HEDGING POLICY
This shows that financing will be employed even when it is not needed. With a hedging approach to financing, the borrowing and payment schedule for short term financing would be arranged to correspond to the expected swings in current assets less spontaneous financing.
The rational behind hedging policy that if long term loans are used to finance the short term or temporary current assets then the firm will be paying interest when the funds are not actually needed. It is clear from the graphical view of the hedging policy that loans will only be employed during the seasonal need period. Hedging approach to financing suggests that apart from current installments on long term debt, a firm should not employ current borrowings during seasonal troughs for asset needs as per the above figure. As the seasonal need asset arises it will borrow on short term basis. This loan will be used to pay off the borrowing with the cash released as the recently financed temporary assets were eventually reduced. For example, a seasonal increase in inventory for Eid selling will be financed with a shot term loan. As the inventory was reduced through sales, debtors will be built up. The cash needed to repay the loan would come from the collection from debtors. In this way financing will only be employed when needed.
Thus loan to support seasonal need would generate necessary fund to repayment in normal course of operation. This is known as self-liquidating principle.
¾ Short Term Vs Long Tem Financing
Although the exact maturity matching of future cash flow and debt repayments is possible under conditions of certainty but it is not appropriate when surrounded by uncertainty. Net cash flow will be off from the estimates keeping in view the firm’s business risk. Resultantly the schedule of maturities of debt is very significant in assessing the risk-profitability trade off.
In general the shorter the maturity schedule of a firm’s debt, the greater the risk that fir firm will default on principal and interest payment. Suppose a firm seeks a short term loan for capital expenditure. The cash flows from the capital expenditure will not be sufficient in the short run to pay off the loan. As a result, the company bears the risk that the lender may not renew the loan at maturity. This refinancing risk could be reduced in the first place by financing the plant on a long term basis – the expected loan term future cash flows being sufficient to retire the debt in an orderly manner. Thus committing funds to a long term asset and borrowing short term carries the risk that the firm may not be able to renew it loan. If the company is surrounded by bad times, the creditors might regard renewal as too risky and demand immediate payment. Apart from refinancing risk, uncertainty is there associated with interest cost. When firm finances with long term loans it is aware of exact interest cost over the period of time for which loans are needed. If it uses short term loans then it is uncertain of interest cost. Secondly, we are well aware that short term interest