Relationship between Company’s I ...
Current assets less current liabilities equals working capital.
$$\text{Working capital = Current assets – Current liabilities}$$
A company’s short-term assets and obligations are managed through working capital management. Its objective is to prevent excess reserves that might be expensive and, consequently, have a detrimental impact on shareholder returns. At the same time, working capital management ensures that a firm has easy access to the money it requires for day-to-day operations.
Companies base their financing choices on market circumstances, legal requirements, and the costs and risks involved for both the firm and the capital provider.
Working capital is represented by cash, accounts receivable, inventories, and marketable securities (short-term investments). In contrast, short-term financing is provided by accounts payable, credit lines, short-term loans, and short-term instruments, such as commercial paper, that a firm issues.
Companies can generate internal financing and liquidity from shorter-term operating activities in several ways, including:
These are a company’s after-tax operating cash flows (adjusted for taxes), minus interest and dividend payments, that can be utilized to invest in assets. A corporation that generates higher, more predictable after-tax operating cash flows can better fund itself internally.
Accounts payable are unpaid amounts owed to suppliers of products and services. They are derived from trade credit, a spontaneous kind of credit in which a buyer of goods or services effectively funds a transaction by deferring payment.
These are amounts that customers owe a company. Companies prefer delaying making payments for what they owe. Interestingly, they, on the other hand, prefer receiving what is owed to them as quickly as possible. The faster a company can collect what it is owed, the lesser its need to finance its operations in some other way.
Inventory is a current asset on the balance sheet. Investing in and holding inventory costs money. Companies had rather not invest a significant amount in inventory when they could spend the money on more productive activities.
Marketable securities are financial instruments, such as stocks and bonds, that can swiftly be sold and converted into cash. Companies frequently invest in marketable securities to obtain a higher rate of return than they would if they held cash.
These include both bank and non-bank lenders. Short-term bank financing includes uncommitted bank lines of credit, committed bank lines of credit, and revolving credit agreements.
Uncommitted lines of credit: These are the least reliable. A bank can provide an uncommitted line of credit for a lengthy period, but it retains the authority to refuse any request to use it.
Committed (regular) lines of credit: These are reliable because of a bank’s formal commitment. They are in effect for less than a year, ensuring that they are classified as short-term liabilities on financial statements. In addition, they are unsecured.
Revolving credit arrangements or revolvers: They are the most reliable form of short-term bank borrowing. They have been in effect for multiple years. Borrowers can draw down and pay back amounts periodically.
Secured loans, also known as asset-based loans, require companies to provide collateral against a loan. These may be available to companies with credit quality to qualify for unsecured loans.
Through the assignment of accounts receivables, receivables can be used as collateral for loans, enabling a business to generate cash flows from its accounts receivables.
In a factoring deal, a business can also sell its accounts receivable to a lender, also known as the factor, for a discount. The factor subsequently assumes the task of collecting the receivables.
Web-based or non-bank lenders are recent innovations that offer loans in small amounts and operate primarily on the internet.
Short-term commercial paper: This is a short-term unsecured loan instrument usually issued by a large company with a good credit rating. They typically range from a few days to 270 days. The issuer’s good credit rating and short-term nature make them low-risk investments for investors.
Long-term Debt: Long-term debt is a debt with a maturity of over one year. Remember that money market instruments have maturities of less than a year, notes have maturities of between one to ten years, and bonds have maturities of over ten years. Due to their long-term maturities, bonds are riskier than notes and money market instruments. For this reason, lenders and borrowers will agree to bond covenants that specify a lender’s rights and restrictions on the borrower.
Common Equity: Common equity represents ownership in a company and is considered a long-term source of funds. Shareholders receive dividends and are entitled to the residual value of a company’s assets if the company goes out of business. They also elect the directors and therefore control the management of a company.
Question
Which of the following is least likely a short-term financing method?
- Common equity.
- Commercial paper.
- Revolving credit arrangements.
The correct answer is A.
Common equity is a long-term external option for financing. It represents ownership in a company. Shareholders receive dividends and are entitled to the residual value of a company’s assets if the company goes out of business.
B is incorrect. Commercial paper is a short-term unsecured loan instrument usually issued by a large company with a good credit rating. It typically ranges from a few days to 270 days.
C is incorrect. Revolving credit arrangements, also known as revolvers, are short-term bank borrowing in which borrowers can draw down and pay back amounts periodically.