The profitability considerations as above suggest the advisability of keeping to a low proportion of current assets to total assets and a high proportion of current liabilities to total liabilities (which must equal total assets). This strategy will, of course, result in a low level of NWC; or, even, negative working capital - to recall the CAPTIM curve discussed in next Unit .
If the firm has stable policies with respect to payment of purchases, labour, taxes and other expenses, then accounts payable and accruals included in current liabilities do not affect decisions in assets management - particularly their financing. The said current liabilities finance a portion of the current assets (e.g., bills payable leave inventory on hand) and these tend to fluctuate with the production schedule, and, in the case of taxes,with profits. That is to say, as investment in current assets grows, accounts payable and accruals also grow, and finance, in part, the build up in assets. How assets not supported by accounts payable and accruals are to be financed is the theme ofthe determination of financing mix.Whatever part of current assets are not financed with short-term sources (i.e. current liabilities) have to be financed by long-term sources such as share capital, long-term borrowing, internally generated and ploughed back resources like retained earnings, etc.What is the relative proportion of financing the current assets by current liabilities on the one hand and by long-term resources on the other is the subject of study of the financing mix.
Essentially, two approaches are available :
(a) Hedging (or Matching) approach, and
(b) Conservative approach.
Hybrid of the two approaches is also in vogue.
Hedging Approach
If each asset would be offset with a financing instrument of the same approximate maturity, the firm is said to have adopted a hedging approach. Short-term variations in current assets (CD in Figure ) would be financed with short-term debt; the permanent component of the current assets (BC in Figure 20.1) would be financed with long-term debt or equity. Since maturities of (short-term) debts are matched with maturities of financial needs, this is called a matching approach. There would, therefore, be no NWC.
If the firm has stable policies with respect to payment of purchases, labour, taxes and other expenses, then accounts payable and accruals included in current liabilities do not affect decisions in assets management - particularly their financing. The said current liabilities finance a portion of the current assets (e.g., bills payable leave inventory on hand) and these tend to fluctuate with the production schedule, and, in the case of taxes,with profits. That is to say, as investment in current assets grows, accounts payable and accruals also grow, and finance, in part, the build up in assets. How assets not supported by accounts payable and accruals are to be financed is the theme ofthe determination of financing mix.Whatever part of current assets are not financed with short-term sources (i.e. current liabilities) have to be financed by long-term sources such as share capital, long-term borrowing, internally generated and ploughed back resources like retained earnings, etc.What is the relative proportion of financing the current assets by current liabilities on the one hand and by long-term resources on the other is the subject of study of the financing mix.
Essentially, two approaches are available :
(a) Hedging (or Matching) approach, and
(b) Conservative approach.
Hybrid of the two approaches is also in vogue.
Hedging Approach
If each asset would be offset with a financing instrument of the same approximate maturity, the firm is said to have adopted a hedging approach. Short-term variations in current assets (CD in Figure ) would be financed with short-term debt; the permanent component of the current assets (BC in Figure 20.1) would be financed with long-term debt or equity. Since maturities of (short-term) debts are matched with maturities of financial needs, this is called a matching approach. There would, therefore, be no NWC.
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| Hedging Financing Policy |
It is to be noted that this approach avoids the following : to finance short-term requirements (CD in Figure ) with long-term debt. If this were not avoided, it would necessitate the payment of interest for the use of the funds during times when they were not needed. With the hedging approach, the borrowing and payment schedule for short-term financing would be so arranged as to correspond to the variations in current assets (the CD part of BD in Figure ), less payables and accruals. When the business is in a growth mode, permanent financing (AC in Figure ) would be increased commensurately with increases in requirements of permanent funds.
Conservative Approach
If the firm wants to provide a margin of safety for the management of current assets by providing for a part of current assets through long-term financing, the firm is said to adopt a conservative approach. In Figure , the part B'C' of the current assets B'D' is financed through long-term funds and only the balance part C'D' of the current assets B'D' is financed with short-term funds.
The margin of safety will depend on the risk preferences of the management. The firm can also create a margin of safety by increasing the proportion of liquid assets.
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| Consecvative Ftganclng Poky |
The extremely conservative approach to the financing policy would be to extend the long-term financing upto the level of the dotted line, thus, covering the maxima of the seasonal variations in the requirements for current assets under long-term financing.Since long-term funds are costlier, the more the line through C (or C') (in the figures) moves towards D (or D3 (in the figures), the cost of the financing policy will increase,i.e. the more conservative the approach, the costlier it is.
Cost Involved in the Financing Policy : Comparison between the Two Approaches
Consider the total requirement of funds for the months April to March as under,successively, in units of thousands of rupees :
April (68); May (60); June (65);
July (70); August (85); September (75);
October (69); November (63); December (60);
January (72);Febmary (83); March (76).
Hedging approach will provide for long-term funds of 60 units and let the rest be taken care of by short-term borrowings. Consider also an alternative conservative approach in which 72 units will be provided from long-term funds, and, balance, if any, will have to be financed by short-term funds.
Cost of short-term funds is 1.5% p.m. (i.e. 19.562% p.a.) and of long-term funds is 2% p.m. (i.e. 26.824% p.a.).
Let us, now, compute the cost of financing under each policy.
Rigorous Method
Hedging Policy
(a) For the Variable Component (above 60 units) : Cost of Financing For the month of April, excess required for variable component is 8 units. Its interest till end of April is 8 x 0.015 = 0.120 units. This cames interest for the balance of 11 months till the end of March, amounting to 0.120 (1.015)" = 0.14135 units.
Computations are made for other months also likewise.
Cost Involved in the Financing Policy : Comparison between the Two Approaches
Consider the total requirement of funds for the months April to March as under,successively, in units of thousands of rupees :
April (68); May (60); June (65);
July (70); August (85); September (75);
October (69); November (63); December (60);
January (72);Febmary (83); March (76).
Hedging approach will provide for long-term funds of 60 units and let the rest be taken care of by short-term borrowings. Consider also an alternative conservative approach in which 72 units will be provided from long-term funds, and, balance, if any, will have to be financed by short-term funds.
Cost of short-term funds is 1.5% p.m. (i.e. 19.562% p.a.) and of long-term funds is 2% p.m. (i.e. 26.824% p.a.).
Let us, now, compute the cost of financing under each policy.
Rigorous Method
Hedging Policy
(a) For the Variable Component (above 60 units) : Cost of Financing For the month of April, excess required for variable component is 8 units. Its interest till end of April is 8 x 0.015 = 0.120 units. This cames interest for the balance of 11 months till the end of March, amounting to 0.120 (1.015)" = 0.14135 units.
Computations are made for other months also likewise.
0bservation
(i) The conservative policy is costlier by 1.66591 units, than the Hedging Policy.
(ii) Rather than working out in such detail, approximate computations can be done as follows.
Approximate Method
Cost of Hedging Policy
(a) Consider the average of the month-wise short-term loans. This is
[8+0+5+10+25+9+15+3+0+12+23+16]/12=(126/12) =10.5 units.
Applying the interest rate on this for 1 year, cost of the short-term funds,= 10.5 x 19.562% .; 2.05401 units (which is close to the rigorous value of 2.04709 units.(b) Cost of financing the permanent requirement of 60 units is, as before,= 16.09451 units.
(c) Total cost of Hedging policy, by summating, = 18.14852 units.
Cost of Conservative Policy
(a) Consider the average of the month-wise short-term loans (above 72 units).
[0+0+0+0+13+3+0+0+0+0+11+4]/12=
=31/12 units.
Applying the interest rate on this for 1 year, cost of the short-term funds
(31/12) x 19.562% = 0.50535 units.
(b) Cost of financing the conservative permanent requirement of 72 units is, as before, = 19.31341 units.
(c) Total cost of conservative policy, by summating; = 19.81 876 units (this being in excess by 1.67024 units over the total cost of Hedging policy).
0bservation
The values are matching to the second decimal point.
Trade-off between the Approaches : By Cost and Risk
Based on the illustrative example worked out above, it can be inferred that the eostaf the financing plan (i.e. the financing mix between short-term and long-term loans) has its effect on the profitability of the firm, because of the ccst involved in the financing plan.The conservative approach for financing is more expensive since the available funds (under the permanent requirement) are not fully utilised during certain periods; moreover interest, at a higher rate, has to be paid on the unutilised funds also (for periods when not needed) (i.e. in the periods when there exists NWC). But during other periods, there is no NWC, a i d hence, this involves some risk.If the ultimate conservative approach had been resorted to, long-term funds would have been upto 85 units, being the largest monthly requirement (in August). The cost of this policy would be : 85 x [(1.02)12 - I] = 22.80055 units. NWC would be available most of the time and there will be little risk involved. Profitability will be also the least because cost of financing is the highest possible.For the hedging approach, there will be no NWC at anytime and hence, risk will be highest. But profitability too will be highest since cost of financing is the least possible.The above statements can be re-worded as follows. Hedging approach is a high profit (low cost), high risk (no NWC) approach for adoption as the financing mix. The fully conservative approach, on the other hand, is a high cost (low profit), high NWC (low risk) approach. There is trade-off between profitability and risk in the adoption of any other intermediate approach, or any level of conservatism in the financing plan.
Besides the availability, or otherwise, of NWC, yet another reason why the hedging plan is risky is as follows. The hedging approach for financing mix uses the short-term funds to full capacity. In emergency situations, it may be difficult to satisfy short-term demands. Contrarily, under the conservative approach, the firm does not use any of its short-term borrowing capacity. Hence, the firm can well and fully fall back on its unused borrowing capacity to tide over any unforeseen financial needs and thereby avoid technical insolvency. This decreases riskiness considerably with the conservative approach.
Yet another reason that may further compound the high riskiness in the hedging approach is the uncertainty regarding interest rates to be paid for the short-term loans, which,theoretically under this approach, are settled as soon as possible. Whereas the firm generally knows its interest costs for financing with long-term debt, it is often uncertain of interest costs upon refinancing through short-term loans. The general economic trend in the society can further upset this uncertainty in times of inflationary trends when the cost of short-term loans then taken may turn out to be more than that of long-term loans taken earlier. If corporate profits should decline simultaneously with inflationary trends for cost of funds, the firm could well get into deep trouble in servicing the short-term loans under the hedging approach.One more strong reason for the high risk under the hedging approach is based on the risk of the firm being unable to meet the repayment schedule for the short-term loan. On the other hand, the longer the maturity schedule, the less risky the financing of the firm.It should be interesting to relate the above study with the concept of "IDC" .
Methods of Reducing Risk
Summarising the above viewpoints, it can be said that, in general, the longer the maturity schedule of a firm's debt in relation to its expected net cash flows, the less the risk. The major risk in this context is due to any possible inability to service and refinance any short-term debt at its maturity.To be afloat, the firm must resort to a financing plan which is a trade-off between risk and profitability. In this connection, it 1s well to recollect the refrain of the above discussions, viz. short-term debt, in general, has greater risk, though with less cost. The margin of safety ava~lable to the firm is based on the time lag between the firm's expected net cash flow and the obligatory schedule of payments to settle its debts. The availed margin of safety will depend upon the risk preferences of the management. [It is for th~p purpose that cash budgets are drawn up - vide later sections.] In any case, the risk preference should not be incompatible with the objective of maximising owners' (i.e. ordinary shareholders') wealth.
If the firm can borrow in times of emergency, the conceptual framework discussed above can be modified in accordance with that ability. "Revolving credits" are one way of acquiring such ability. Also, the efficiency of credit and collection procedures and inventory management has a great influence in reducing the risk thereby firming up the liquidity of the firm.
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