Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing

<< Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate

Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash >>

Corporate Finance FIN 622

Lesson 27

WORKING CAPITAL MANAGEMENT

The 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

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.

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.

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

HEDGING POLICY

TEMPORARY CA

SHORT TERM LOANS

PERMANENT CA

LONG TERM LOANS

NON CURRENT ASSETS

TIME

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.

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

Corporate Finance FIN 622

rates fluctuate more than long term. A firm forced to finance its short term debt in a period of high interest

rates may pay on overall interest cost on short term loan that is higher than it would have been originally on

long term loan. In short not knowing the short term interest cost of loans is to some extent a risk to the

company.

The Risk Vs Cost Trade off:

The risk between long and short term financing should be balanced against the interest costs. The longer

the maturity schedule of loan, the more expensive will be the financing. Further to this, the firm will be

paying interest cost on loans when the loans / debts are not needed. Therefore, there are cost inducements

to finance funds requirements on a short term basis.

Eventually we can work out the trade off between risk and profitability. As per our discussion over last

couple of pages, we know that short term loans have greater risk than long term loans but are comparatively

cheap. The margin of safety would depend on the variance between the cash flow and payment of debt.

Also, margin of safety will depend on the risk preference of the management.

The management will finance a part of its expected seasonal investment, less payables and accruals on long

term basis. If there's no deviation in cash flow as estimated, the firm will pay interest on excess debt during

seasonal dips when the funds are not needed. Peak season requirements can be financed through long term

loan. The higher the long term loans the more conservative financing policy and therefore, the higher

interest cost.

Under aggressive policy the firm would finance part of its permanent current asset with short term debts.

This would require that firm must renew the debt at maturity, which represents some risk to the firm. The

greater the portion of permanent assets financed with short term loans, the more aggressive the policy is. In

this case, the expected margin of safety linked with firm's policy can be negative, positive or even zero.

Now we are in a position to sum up our discussion or conservative and aggressive policies. Here are the

salient features of both policies with regard to investment in current assets:

Conservative Policy:

o Firm finances a part of seasonal fund requirements less accounts payable on long term basis.

o If cash flow estimates do not deviate far from actual, it will pay interest on debt when actually

funds are not needed.

o Higher the long term financing line, more conservative policy and higher cost.

Aggressive Policy:

Part of permanent current assets is financed with short term debt.

The company must arrange renewal of short term debt. It involves risk.

The greater portion of permanent current assets is financed with short term debt, more

aggressive policy it is.

Expected margin of safety regarding ST <> LT financing can be positive, negative or

neutral. Later would be hedging policy.

Margin of safety can be increased by increasing the liquid assets.

Risk of cash insolvency can be reduced by stretching the maturity schedule of debt or

carrying larger amounts of current assets

Table of Contents: