chap 4

Chapter 4 Part II Management Of Current Assets

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The working capital management involves day-to-day decisions regarding investment in

current assets, and how the assets are to be financed. The primary purposes of this

chapter are (1) to review alternative strategies for investing in working capital, and (2) to

discuss alternative strategies for financing working capital. Decisions in these two areas

will affect both the firm's riskiness and its expected rate to return, and hence its market

values.

CURRENT ASSETS INVESTMENT POLICIES

The objective of managing working capital is to achieve risk-return tradeoffs that

maximize the value of the firm. As such, current assets must be available at all time to

support the firm's operations while maintaining its holdings to a minimum amount to

reduce investment and, hence the cost of financing. There are three basic policies that

the company can adopt that are relaxed policy, restricted policy, and moderate policy.

Relaxed policy

This is a low risk policy; whereby the firm will maintains large amount of current assets

coupled with liberal credit policy. It has high liquidity, and potentially low return from

investments due to low productivity of current assets relative to fixed asset.

Working

Capital

Management

Part II Management Of Current Assets Chapter 4

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Restricted policy On the other hand, restricted policy is a high-risk policy whereby it reduces current

assets' holding to a minimum coupled with stringent credit policy. Lower investments in

current assets enable the firm to increase investment in other productive investments,

and thus will results in higher returns.

Moderate policy

This is middle the road policy in between relaxed and restricted policies. It will result in

moderate risk and returns. High current assets' investments such under relaxed policy

will reduce risk of technical insolvency, but at the same time it will results in lower returns

due to lower productivity of current assets. Therefore, investment in current assets

should be at a minimum level without sacrificing the liquidity requirements. As such more

funds are available for investment in fixed assets that are more productive.

The use of current liabilities or short term financing to finance current assets are

generally less expensive than long-term financing such as long-term debt, preferred

stock, and common equity. Short-term financing represents a relatively lower cost of

capital and could improve the firm's profitability. Consequently, aggressive use of short-

term financing lead to a decrease in net working capital, and hence increases the risk of

technical insolvency.

WORKING CAPITAL STRATEGIES

Working capital strategies range from the aggressive to the conservative approach, in

which each will produce different levels of profitability and risk exposure. To the extreme,

aggressive policy sacrifices safety or liquidity for return, and conservative policy

sacrifices return for safety. Under whatever conditions, the basic risk-return tradeoff will

definitely apply; that is higher risk will result in corresponding higher return.


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The typical firm normally has production and sales cycles that vary during the course of

its operations; these cycles will cause the current assets of the firm to fluctuate over

time. It is accepted that most firms have a base of both fixed assets and permanent

current assets to support operations. Similarly, there is some level of current assets that

will be varying with the business cycles of the firm, and that the firm must consider how it

will finance these various types of assets. This suggests that certain assets are

temporary in nature and others are permanent.

Permanent Assets. It refers to all assets, fixed or current, that is necessary for the firm

to hold at all time regardless of the firm's sales level. Fixed assets are permanent in

nature since it is inflexible in the short-term. Simultaneously, certain amount of current

assets should be on hand to support operations even if the sales activity is at the lowest,

such as a minimum amount of cash. This part of current assets is, therefore regarded as

permanent.

Temporary Assets. It refers to part of current assets that fluctuates directly with

changes in sales level. It is the additional current assets required to support the increase

in sales. This concept is in line with the principles of percentage of sales method,

discussed in previous chapter.

Similarly, the above classifications will also apply to liabilities and equity. All equity, long-

term debts are permanent source of funds. Certain components of short-term borrowing

or current liabilities are permanent in nature to finance permanent current assets, while

others are temporary to support the need for temporary current assets' investments.

The working capital strategies or approaches presented in the following sections will

show the methods of financing these assets. In each of the approaches presented, the

total requirements to finance temporary current assets are net of spontaneous financing

generated from spontaneous liabilities; such as from accounts payable and accruals.


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Hedging Approach

The hedging approach matches the maturity of assets and liability that is the firm use

temporary financing to finance temporary current assets and permanent financing to

finance permanent assets. In this plan, therefore, the firm would finance fixed and

permanent current assets with long-term debt, while the fluctuating current assets will be

financed with short-term debt. Refer to Figure 4.1 for graphic illustrations.

Figure 4-1 The Hedging Approach

Ringgits Short-term or temporary financing TCA PCA Permanent plus spontaneous financing Fixed assets Time Where TCA : Temporary current assets

PCA : Permanent current assets

Since the approach matches the financing maturity and the assets' requirements, there

is no need for emergency funds and idle funds are non-existence. This approach results

in moderate risk with moderate returns. A firm wishing to adopt a financially aggressive

or conservative approach may modify the above approach by focusing on using more of

temporary financing or permanent financing respectively.


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Aggressive Approach

This strategy involves more risk, as it partially matches the maturity of assets and

liability. It uses short-term or temporary financing to support a relatively large portion of

current assets. In this plan, a firm would finance all fixed assets with long-term financing,

but only a portion of the permanent current assets would be financed long-term. The

remaining permanent and the fluctuating current assets would be financed with short-

term borrowing.

This approach is more risky for the firm because the current ratio is less than one and

there are potential problems in renewing the short-term borrowing arrangements.

However as we will see in a later section, short-term debt is often cheaper than long-

term debt, so many firms may be willing to sacrifice safety for possibly higher profits.

Refer to Figure 4.2 for graphic illustration.

Figure 4-2 The Aggressive Approach

Ringgits Short-term or temporary financing TCA PCA Permanent plus spontaneous financing Fixed assets Time

Conservative Approach

This approach has the lowest risk among the working capital approaches; whereby the

firm uses long-term financing for the majority of its assets; resorting to the use of short-

term financing only for the very peak requirements. Refer to Figure 4.3 for graphic

illustration.


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Figure 4-3 The Conservative Approach

Ringgits Marketable securities Short-term or temporary financing TCA PCA Permanent plus spontaneous Fixed assets financing Time

In this plan, the firm supports fixed, permanent current assets, and average temporary

current assets with long-term financing. Then, during slow periods when the need for

temporary current assets is low, the firm will have excess liquidity and buys short-term

securities; alternatively, when the need for current assets is at a peak the firm sells off its

short-term liquid investments and borrows short-term if necessary.

Most of the time, the firm will have excess liquidity and this reduces the need for

temporary financing, hence it results in lower risk of technical insolvency. Conversely,

the returns are low. This is due to higher costs of permanent financing and low returns

from marketable securities investment. Both of these factors combined will result in a

relatively low average return.

Given the three alternative strategies, which approach to maintain appropriate level of

liquidity or margin of safety is the best? There is no right answer, and it will depend on

the:

1. Profitability of the firm;

2. Stability of cash flows;

3. Liquidity of the firm's assets;

4. Management attitude towards risk; and

5. Expected future interest rates.


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Lower level of current assets can protect the firm against technical insolvency given that

the firm has high levels of profitability, stable cash flows, and liquid assets. Other things

held constant, these conditions may suggest a more aggressive approach is appropriate.

On the other hand, if the above conditions are reversed, a more conservative approach

is then appropriate.

In the case of interest rates, the expectation of higher future rates will lead to more use

of long-term financing. This will ensure that the firm is able to enjoy a lower interest rate

although the rate goes up later. In this case, hedging and conservative approaches are

most likely to be adopted.


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FINAL EXAM QUESTIONS April 2003: Section B. Question 1 (b) Explain Aggressive Approach in working capital management by using a graph. (5 marks) March 2002: Section B. Question 2 (b) By using graphs, explain the three approaches in working capital management. (5 marks) April 2001: Section B. Question 2 (a) Define the hedging principle. How can this principle be used in the management of working capital. (5 marks) April 2000: Question 7 (a) Explain the Aggressive Approach in working capital management using a graph. (4 marks) October 1998: Question 7 (b) With the help of a diagram, explain the hedging approach in working capital management. (5 marks)


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QUESTIONS

4-1 Explain how current assets' investment policies affect the firm's risk and

return tradeoffs.

4-2 What is meant by aggressive approach to working capital?

4-3 Explain the key differences between the hedging and conservative

approach to working capital management?

4-4 If you are running a grocery store, which approach of working capital

management is appropriate? Why?

4-5 Why certain assets are said to be permanent and others is temporary? In

order to perfectly manage permanent assets, only permanent financing

should be used. Do you agree? Why?


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