Foundations of Financial Management: An Analysis (part 17)

“To contract new debts is not the way to pay old ones.”

~George Washington~

Working Capital and the Financing Decision

(part C)

by

Charles Lamson 

Patterns of Financing

The financial manager's selection of external sources of funds to finance assets may be one of the firm's most important decisions. The axiom that all current assets should be financed by current liabilities (accounts payable, bank loans, commercial paper, etc.) is subject to challenge when one sees the permanent buildup that can occur in current assets. In the Yawakuzi example from last post, the build-up in inventory was substantial at $9 million. The example had a logical conclusion in that the motorcycles were sold, cash was generated, and current assets became very liquid. What if a much smaller level of sales had occurred? Yawakuzi would be sitting on a large inventory that needed to be financed and would be generating no cash. Theoretically, the firm could be declared technically insolvent (bankrupt) if short-term sources of funds were used but were unable to be renewed when they came due. How would the interest and principal be paid without cash flow from inventory liquidation? The most appropriate financing pattern would be one in which asset build-up and length of financing terms are perfectly matched, as indicated in Figure 5.

Figure 5

In the upper part of Figure 5 we see that the temporary buildup in current assets represented by orange is financed by short-term funds. More importantly, however, permanent current assets and fixed assets both represented by blue are financed with long-term funds from the sale of stock, the issuance of bonds, or retention of earnings.

Alternative Plans

Only a financial manager with unusual insight and timing could construct a financial plan for working capital that adhered perfectly to the design in Figure 5. The difficulty rests in determining precisely what part of current assets is temporary and what part is permanent. Even if dollar amounts could be ascertained, the exact timing of asset liquidation is a difficult matter. To compound the problem, we are never quite sure how much short-term or long-term financing is available at a given time. While the precise synchronization of temporary current assets and short-term financing depicted in Figure 5 may be the most desirable and logical plan, other alternatives must be considered.

Long-Term Financing 

To protect against the danger of not being able to provide adequate short-term financing in tight money periods, the financial manager may rely on long-term funds to cover some short-term needs. As indicated in Figure 6, long-term capital is now being used to finance fixed assets, permanent current assets, and part of temporary current assets. 

Figure 6

By using long-term capital to cover part of the short-term needs, the firm virtually assures itself of having adequate capital at all times. The firm may prefer to borrow a million dollars for 10 years rather than attempt to borrow a million at the beginning of each year for 10 years and pay it back at the end of each year.

Short-Term Financing (Opposite Approach)

This is not to say that all financial managers utilize long-term financing on a large scale. To acquire long-term funds, the firm must generally go to the capital markets with a bond or stock offering or must privately place longer-term obligations with insurance companies, wealthy individuals, and so forth. Many small businesses do not have access to such long-term capital and are forced to rely heavily on short-term bank and trade credit.

Furthermore, short-term financing offers some advantages over more extended financial arrangements. As a general rule, the interest rate on short-term funds is lower than on long-term funds. We might surmise then that a firm could develop a working capital financing plan in which short-term funds are used to finance not only temporary current assets, but also part of the permanent working capital needs of the firm. As depicted in Figure 7, bank and trade credit as well as other sources of short-term financing are now supporting part of the permanent capital asset needs of the firm.

Figure 7

The Financing Decision

Some corporations are more flexible than others because they are not locked into a few available sources of funds. Corporations would like many financing alternatives in order to minimize their cost of funds at any point. Unfortunately, not many firms are in this enviable position through the duration of a business cycle. During an economic boom period, a shortage of low-cost alternatives exists, and firms often minimize their financing costs by raising funds in advance of forecasted asset needs.

Not only does the financial manager encounter a timing problem, but he or she also needs to select the right type of financing. Even for companies having many alternative sources of funds, there may be only one or two decisions that will look good in retrospect. At the time the financing decision is made, the financial manager is never sure it is the right one. Should the financing be long-term or short-term, debt or equity, and so on? Figure 8 is a decision-tree diagram that shows many of the financing choices available to a chief financial officer. A decision is made at each point until a final financing method is chosen. In most cases a corporation will use a combination of these financing methods. At all times the financial manager will balance short-term versus long-term considerations against the composition of the firm's assets and the firm's willingness to accept risk. The ratio of long-term financing to short-term financing at any point in time will be greatly influenced by the term structure of interest rates.

Figure 8 Decision tree of the financing decision

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 153-161*

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