WORKING CAPITAL

AND THE
FINANCING DECISION

Under the guidance of: Submitted by:

Dr. Angelina Tagay Isabel Ganir

Eunice Francia Macagba
FM104 Instructor Aira Jerrilie Acdan
Keith Ann Buduan
Amiel Joseph Mata
Louele Ace Cabacungan
Gino Serrano
BASIC CONCEPTS

Working Capital - sometimes referred to as gross working capital simply refers to

current assets.

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.

Financing Decision – relates to acquiring the optimum finance to meet financial

objectives and seeing that fixed and working capital needs are effectively managed. It is
also concerned with the determination of the source of financing, the proportion of
equity and debt.

REASONS WHY WORKING CAPITAL MANAGEMENT IS IMPORTANT

 Working capital comprises a large portion of the firm’s total assets.

 The financial manager has considerable responsibility and control in managing the
level of current assets and current liabilities.
 Working capital management directly affects the firm’s long-term growth and
survival.
 Liquidity and profitability are likewise directly affected by working capital
management.
 How much inventory should the company hold?
 How much should the firm borrow in the short-term?

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. Working capital represents a margin of safety for short-term creditors.

Current assets are likely to yield a higher percentage of their book value on
liquidation than do fixed assets. Hence, short-term creditors look to the current asset
as a source of repayment of their claims. The working capital also indicates the
amount by which the value of current assets could drop from their book values and
still cover the claims of short-term creditors without loss.

2. The amount of working capital represents the extent to which current

assets are financed from long-term sources.

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 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.

WORKING CAPITAL POLICY

Working capital policy involves two basic questions:

1. What is the appropriate level for current assets, both in total and by specific
accounts? and
2. How should current assets be financed?

Factors Affecting Level of Current Assets

1. The Nature of Operations.

2. Effect of Sales Pattern.
3. Length of the Manufacturing Process
4. Industry Practices
5. Terms of Purchases and Sales.

Advantages of Adequate Working Capital

1. The company can settle its debts promptly.

2. Credit may be extended to customers.
3. Inventories can be readily replenished.
4. Current operating expenses are paid promptly.
5. Management and employee morale is enhanced.
6. Profitable opportunities can be taken advantage of.

Disadvantages of Inadequate Working Capital

1. Business failure.
2. The company may not able to pursue its objectives because of lack of funds.

Disadvantages of Excessive Working Capital

1. Management may become inefficient and complacent.

2. Management may be tempted to speculate.
3. Unnecessary expenses and extravagance may result.
4. Resources are not optimally employed.

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ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES

1. Conservative Approach or Relaxed Current Investment Policy

- 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

2. Aggressive Or Restricted Current Asset Investment Policy

- 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

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3. Moderate Current Assets Investment Policy

- A policy between the relaxed and restricted policies

- A moderate approach to current assets financing involves the matching to the
extent possible the maturities of assets and liabilities, so that the temporary
current assets are financed with short-term no spontaneous debt, and permanent
current assets and fixed assets are financed with long-term debt or equity, plus
spontaneous debt.
- This policy is also known as “hedging policy” calls for the use of permanent
financing (long-term debt and equity) to finance permanent assets (fixed assets
and permanent working capital) and then the use of short-term financing to
cover seasonal or cyclical temporary assets.
- This strategy minimizes the risk that the firm will be unable to pay off its
maturing obligations.

ALTERNATIVE CURRENT ASSET FINANCING POLICIES

1. Maturity Matching or Hedging Approach

– is a strategy of working capital financing wherein short term requirements are

met with short-term debts and long-term requirements with long-term debts.
The underlying principal is that each asset should be compensated with a debt
instrument having almost the same maturity.

Maturity Matching or Hedging Approach Equation

This matching approach of working capital financing can be explained in terms of
a simple equation as follows:

Long Term Funds will Finance = Fixed Assets + Permanent

Working Capital
Short Term Funds will Finance = Temporary Working Capital

In the equations, long term funds are matched to long term assets and vice versa.

Rationale behind Maturity Matching or Hedging Approach

Knowing why to apply maturity matching strategy is very important. It suggests

financing permanent assets with long-term financing and temporary with short-term
financing. Now let us suppose opposite situations and see. There can two such
situations.

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 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.

b. Temporary Assets Financed with Long Term Financing: In this

situation, firstly, the borrower has to pay interest on long term loans for that
period also when the loan is not getting utilized. Secondly, the interest rate of
long-term loans is normally dearer to short term loans due to the concept of
term premium. These two additional costs hit the profitability of the firm.

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.

Maturity matching approach has various advantages and disadvantages. The

biggest advantages are that it maintains an optimum level of funds, saves cost, no
refinancing risk and interest rate fluctuation risk. The main disadvantage is its
difficulty in implementation.

Maturity matching or hedging approach of working capital financing is an

idealistic approach. It is based on the basic principle of finance that long-term
assets should be financed with long-term sources of finance such as equity; term
loan; debentures etc. and short term assets should be financed with short-term
sources of finance such as short-term loans, current liabilities, cash credit, bank
overdraft, other working capital loans etc.

Advantages of Matching Maturity Approach

Optimum Level of Funds (Liquidity): The funds remain on the

balance sheet only till they are in use. As soon as they are not needed, they are
paid. This is how the interest cost is optimized in this strategy. Interest is paid

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 only for the amount and time for which money is used. There is no unutilized
cash lying idle with the business.

Savings on Interest Costs: When short-term requirements are not funded

with long-term finances, the firm saves interest rate difference between long term
and short term interest rates. It is already known that long-term interest rates are
comparatively higher due to the concept of risk premium.

No Risk of Refinancing and Interest Rate Fluctuations during

Refinancing: Since the fundamental principle of finance is followed here i.e.
long- term asset to long-term finance and short term assets to short term finance,
there is no risk of refinancing and the interest rate fluctuations during
refinancing. This means that while renewing a loan if the market scenario
changes, the rate of interest may also adversely change. Here, there is no problem
of frequent refinancing.

Disadvantages of Matching Maturity Approach

Difficult to Implement: It is one of the best strategies or ideal strategy but it is

very difficult to implement. Exactly matching the maturity of assets with their
source of finance is practically not possible. There is quite a lot of uncertainty on
current asset’s side. One cannot exactly predict at what time, the debtor will pay
or what time the sales will occur. Once the credit is extended, the ball goes in the
court of the debtor.

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.

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Financing Strategy in Equation:

Long Term Funds will Finance = Fixed Assets + Part of Permanent

Working Capital
Short Term Funds will Finance = Remaining Part of Permanent
Working Capital + Temporary Working Capital

Advantages of Aggressive Approach of Working Capital Financing

Lower Financing Cost, High Profitability: In this strategy, the cost of

interest is low because of the maximum usage of short term finances. There are
two reasons of this. Firstly, the rate of interest is cheaper and secondly, in the off
seasons, the loan can be repaid and hence, no idle funds. If the operating cycle is
moving smoothly, it is called most effective working capital management.

Lower Carrying and Handling Cost: Lower level of inventory makes the
carrying and holding cost also go down and that directly affect the profitability.

Highly Efficient Working Capital Management: The task of working

capital manager is to smoothly run the operating cycle of the company with the
lowest level of working capital. Precisely, that is what this strategy is all about. If
the strategy is successful with no dissatisfied stakeholders, there is nothing better
than this.

Disadvantages of Aggressive Approach of Working Capital Financing

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.

Lost Opportunities and Unexpected Shocks: Since, there are no cushions

or margin in this strategy of financing, sudden big contracts of sales are not
possible to execute. On the other hand, if there are other uncertainties like delay
in an abnormal raw material acquisition, machinery break downs etc, the firm
will disturb the business operating cycle and therefore will face sustainability
problems.

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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.

Financing Strategy in Equation:

Long Term Funds will Finance = Fixed Assets + Permanent

Working Capital + Part of Temporary Working Capital
Short Term Funds will Finance = Remaining Part of Temporary
Working Capital

Advantages of Conservative Approach of Working Capital Financing

Smooth Operations with No Stoppages: In this strategy, the level of

working capital and current assets (inventory, accounts receivables and most
importantly liquid cash or bank balance) is high. A Higher level of inventory
absorbs the sudden spurt in product sales, production plans, any abnormal delay
in procurement time etc. This achieves the higher level of customer satisfaction
and smooth operations of the company. Higher levels of accounts receivables
are due to relaxed credit a term which in turn attracts more customer and thereby
higher sales and higher sales mean higher profits in normal circumstances.

No Insolvency Risk: Most important part and highly relevant to financing

strategy are the higher levels of cash and working capital. Higher working capital
avoids the risk of refinancing which exists in case it is financed by short-term
sources of finance. Not only the risk of refinancing but also the risk of adverse
change in the interest rate while getting the short term loans renewed are
avoided. This is how the insolvency risk is avoided as at any time company has
sufficient capital to pay off any liability.

Disadvantages of Conservative Approach of Working Capital Financing

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

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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.

Inefficient Working Capital Management: If the margins of the firm are

low for a particular year, a reasonable part of it will be attributed to working
capital management. In such a situation, the conservative approach of financing
may be called with another name of ‘inefficient working capital management’.

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We will compare these three approaches on 6 parameters viz. liquidity, profitability, risk, asset utilization, and working capital.

Factors Conservative Aggressive Hedging

Liquidity is low due to greater

Liquidity is balanced i.e. neither
Liquidity is high, because of heavy dependability on short-term funds
high nor low. It attempts to strike a
Liquidity usage of long-term funds. It can take even for a part of long-term assets. It
balance between liquidity and cost of
advantage of sudden opportunities. does not keep idle funds and
idle funds.
therefore saves interest cost on them.
Under normal circumstances, Because of cut to cut management, a
profitability is less in this strategy balance is achieved between interest
Since the interest cost is minimized in
because of too much of idle and costly cost and loss of profitability.
Profitability this approach, higher profitability is
funds. Higher rate and bigger Moderate profitability is maintained
obtained.
magnitude of interest cost reduce the here. It is greater than conservative
profitability. and lesser than aggressive.
There is very low risk of bankruptcy
There is a high risk of bankruptcy due Risk is balanced here. The firm will
as a higher level of liquidity is
Risk to extremely tight liquidity position bow down to bankruptcy only in an
maintained in the business in this
being maintained. extremely bad situation.
approach.
Similarly, too low level of current
Too high level of current assets makes
Asset utilization assets makes the utilization ratio Moderate
its utilization ratio low.
high.

Very low working capital is Moderate working capital is

More working capital is required to
maintained. Low working capital maintained to stay somewhere
Working capital execute the conservatism. Higher
increases risk but saves the interest between conservative and aggressive
working capital avoids all risks.
cost. strategies.