FINANCING CURRENT
ASSETS
CHAPTER :5
LEARNING OBJECTIVES
After studying this chapter, you should be
able to:
Explain alternative current asset
financing policies
Elaborate advantages and disadvantages
of short-term financing policies
Explain sources of short-term
financing(accruals, accounts payable,
short-term bank loan, and commercial
papers)
5.0 Introduction
first step in working capital management—
determining the optimal level for each type of
current asset.
the second step—financing those assets.
5.1 Alternative current Asset Financing policies
Most businesses experience seasonal and/or cyclical
fluctuations.
all businesses must build up current assets when the
economy is strong, but they then sell off inventories and
reduce receivables when the economy slacks off.
Still, current assets rarely drop to zero—companies have
some permanent current assets, which are the current
assets on hand at the low point of the cycle.(Current
assets that a firm must carry even at the trough of
its cycles.)
Then, as sales increase during the upswing, current assets
must be increased, and these additional current assets are
defined as temporary current assets(Current assets
that fluctuate with seasonal or cyclical variations in sales).
The firm’s current asset financing policy is
the manner in which the permanent and
temporary current assets are financed.
1. Maturity Matching, or “Self- Liquidating,”
Approach
2. Aggressive approach
3. Conservative approach
5.1.1 Maturity Matching Approach
A financing policy that matches asset and
liability maturities. This is a moderate policy.
This strategy minimizes the risk that the firm
will be unable to pay off its maturing
obligations.
Eg. Inventory expected to be sold in 30 days
could be financed with a 30-day bank loan; a
machine expected to last for 5 years could be
financed with a 5-year loan; a 20-year building
Actually, two factors prevent this exact
maturity matching:
a. there is uncertainty about the lives of
assets, and
b. some common equity must be used, and
common equity has no maturity.
In practice, firms don’t finance each
specific asset with a type of capital that has
a maturity equal to the asset’s life.
5.1.2 Aggressive approach
relatively aggressive firm finances all of its fixed
assets with long-term capital and part of its
permanent current assets with short-term,
nonspontaneous credit.
called for the greatest use of short-term debt.
5.1.3 Conservative approach
the firm uses a small amount of short-term,
nonspontaneous credit to meet its peak
requirements, but it also meets a part of its
seasonal needs by “storing liquidity” in the
form of marketable securities.
a very safe current asset financing policy.
called for the least use of short -term financing
5.2 Advantages and disadvantages of short-
term financing
Although short-term credit is generally less
risky than long-term credit, using short-term
funds does have some significant advantages.
The pros and cons of short-term financing are
considered as follows.
5.2.1 Merits of short-term financing
1. SPEED-
A short-term loan can be obtained much faster than
long-term credit.
if funds are needed in a hurry, the firm should look to
the short term markets.
2. FLEXIBILITY-If its needs for funds are seasonal or
cyclical, a firm may not want to commit itself to long-
term debt for three reasons:
i. Flotation costs are higher for long term debt than for
short-term credit.
ii. Although long-term debt can be repaid early,
provided the loan agreement includes a prepayment
provision, prepayment penalties can be expensive.
iii.Long-term loan agreements always contain
provisions, or covenants, which constrain
the firm’s future actions. Short-term credit
agreements are generally less restrictive.
3. INTEREST
under normal conditions, interest costs at the
time the funds are obtained will be lower if the
firm borrows on a short-term rather than a
long-term basis.
5.2.2 Demerits of short-term financing
Even though short-term rates are often lower
than long-term rates, short-term credit is
riskier for two reasons:
1. If a firm borrows on a long-term basis, its
interest costs will be relatively stable over
time, but if it uses short-term credit, its
interest expense will fluctuate widely, at times
going quite high.
2. If a firm borrows heavily on a short-term
basis, a temporary recession may render it
unable to repay this debt.
5.3 Sources of short-term financing
There are numerous sources of short-term
funds, of which four major types will be
discussed as follows:
1. Accruals
2. accounts payable (trade credit)
3. bank loans, and
4. commercial paper.
1. Accruals
Continually recurring short-term liabilities,
especially accrued wages and accrued
taxes.
Firms generally pay employees on a
weekly, biweekly, or monthly basis, so the
statement of financial position will typically
show some accrued wages.
firms use all the accruals they can, but
they have little control over the levels of
these accounts.
2. Accounts payable (trade credit)
Debt arising from credit sales and recorded as an
account receivable by the seller and as an
account payable by the buyer.
Accounts payable, or trade credit, is the largest
single category of short-term debt, representing
most portion of the current liabilities of the
average nonfinancial corporation.
Trade credit is a “spontaneous” source of
financing in the sense that it arises from ordinary
business transactions.
3. Short-term bank loans
Commercial banks are second in importance
to trade credit as a source of short-term
financing for non-financial corporations.
The banks’ influence is actually greater than it
appears from the dollar amounts because
banks provide nonspontaneous funds.
As a firm’s financing needs increase, it
requests additional funds from its bank. If the
request is denied, the firm may be forced to
abandon attractive growth opportunities.
The key features of bank loans are:
i. Maturity
ii. Promissory note- a document specifying
the terms and conditions of a loan,
including the amount, interest rate, and
repayment schedule.
iii. Compensating balances- a minimum
checking account balance that a firm must
maintain with a commercial bank,
generally equal to 10 to 20 percent of the
amount of loans outstanding.
4. Commercial paper
a type of unsecured promissory note issued
by large, strong firms and sold primarily to
other business firms, to insurance
companies, to pension funds, to money
market mutual funds, and to banks.
Use of commercial paper:
restricted to a comparatively small number of very
large concerns that are exceptionally good credit
risks.
One potential problem with commercial paper is
that a debtor who is in temporary financial
difficulty may receive little help because
commercial paper dealings are generally less
personal than are bank relationships.
Thus, banks are generally more able and willing to
help a good customer weather a temporary storm
than is a commercial paper dealer.
END OF CHAPTER -5
