Managing Working Capital and Liquidity

The main objective of liquidity and working capital management is to maximize the value of a firm while ensuring ready access to capital to pay creditors and for day-to-day operations. To accomplish this, reducing the cash conversion cycle, gauging liquidity requirements, and reducing surplus funds is essential. This ensures the company can divert money to profitable ventures or give it back to shareholders while aligning with its business framework.

Different industries and businesses within the same industry have different working capital requirements. Manufacturing businesses with complex production processes may require holding inventory for extended periods, while distributors of less complex goods may have minimal inventory. Retail businesses with multiple sales locations and credit sales require more working capital in inventories and accounts receivable.

Service and software businesses generally have lower working capital requirements as they don’t have inventories and receive upfront payments.

Working Capital Management

Firms approximate working capital requirements based on revenue. Moreover, firms forecast future working capital requirements based on future revenue forecasts. While estimating the working capital requirements, firms usually do the following:

• Differentiating permanent and variable current assets. Permanent current assets include base levels of inventory, staffing, and receivables, which are usually constant over time. Variable current assets are additional inventory and labor required at peak production and sales or growth phase.
• Weighing the cost against the benefits using different inventory and receivables policies. For instance, easy credit policies may result in high billing costs and payment delinquencies.

Working Capital Management and Funding Method

Businesses adopt various strategies regarding the magnitude of their current assets and the type of financing they use to sustain those assets. They include:

Conservative Approach

A conservative approach entails maintaining a higher proportion of inventory, cash, and receivables relative to sales and leaning more toward long-term financing. While this method offers optimal financial adaptability to cater to its requirements, it comes at a higher cost. Organizations in their early-stage growth stage tend to gravitate towards this approach due to restricted short-term borrowing options.

Firms may choose a conservative working capital strategy for the following reason:

1. Lesser dependence on capital during market stress.
2. Anticipation of flat or increasing interest rates
3. Avoidance of rollover risk of short-term debt in favor of cash flow stability.
4. The higher financing costs are perceived to be offset by the benefits of greater certainty and permanent capital.

Advantages of the conservative working capital approach

• Permanent, stable financing prevents the risk of rollover associated with short-term debt.
• The costs of financing are known in advance
• Working capital required to buy inventory is certain.
• Short-term cash needs to service debts are reduced due to extended payment terms.
• More significant cash or marketable securities positions provide greater flexibility during market disruptions.

Disadvantages of the conservative working capital approach

• Higher interest rates due to the use of long-term debt.
• High equity cost.
• The opportunity to borrow on need be basis is eliminated by permanent financing.
• Establishing the financing position often requires a longer lead time.
• Business operations may be restricted by long-term debt.

Aggressive Working Capital Approach

In an aggressive strategy, a company aims to limit surplus cash, receivables, and inventory relative to sales and leans more towards short-term financing to cater to both fluctuating and constant working capital requirements.

Intuitively, by allocating fewer dedicated resources to current assets, the company trades off short-term financial flexibility for increased investor returns.

Working capital policies may be more aggressive in industries with lower profit margins to gain a cost advantage over competitors. When markets are stressed, a firm is more susceptible to debt rollover risk when relying more on short-term financing than a conservative approach.

Firms may choose an aggressive working capital approach for the following additional reasons.

1. Ability to predict future sales and cash requirements with high accuracy.
2. Anticipation of decreasing or stable interest rates.
3. Expectation that the firm will reduce its cash conversion cycle by decreasing the duration of its accounts receivable and inventory periods while lengthening its accounts payable period.
4. Ability to minimize accounts receivable and quickly liquidate inventory.

Advantages of an aggressive working capital approach

• Low financing cost
• Interest expense is low due to the flexibility of borrowing on a need-be basis.
• Fewer restrictions on business operations due to the use of short-term debt.
• If rates fall, it is easier to refinance.

Disadvantages of an aggressive working capital approach

• As rates of short-term financing change, interest expense may fluctuate.
• Higher short-term cash needs may arise to settle debt maturities.
• The refinance risk associated with short-term debt heightens the threat of bankruptcy, especially during market upheavals.
• If refinancing on favorable terms is unattainable, there might be a need to depend on pricier trade credit, restrict customer credit, or liquidate receivables.

Moderate Working Capital Approach

Moderate working capital approaches balance long-term financing for permanent current assets with short-term debt for variable assets. Moderate working capital strategies have lower financing costs and refinancing risks than aggressive approach.

Additionally, these firms can use long-term debt and equity to support permanent needs in addition to reducing working capital. A firm might pursue a moderate approach to working capital management include the following reasons:

1. Capability to precisely predict fundamental current asset needs, though there’s less assurance regarding fluctuating demands.
2. Lower financing expenses compared to a conservative strategy, coupled with decreased refinance risk and enhanced financial flexibility compared to an aggressive approach.
3. To achieve a balance between the use of less costly short-term financing and the security of permanent working capital backed by long-term financing.

Advantages of moderate working capital approach

• Lower risk compared to the aggressive approach and lower financing cost than the conservative approach.
• The flexibility to increase financing for varying requirements or expansion when necessary.
• With a more disciplined approach to balance sheet management, thus diversified sources of funding.
• With a more rigorous method of balance sheet oversight, diversified funding sources exist.

Disadvantages of moderate working capital approach

• Limited access to short-term capital needed for growth or seasonal needs.
• During the market disruption, the cost of short-term debt for variable needs may be uncertain.
• If the company cannot refinance at a favorable rate, it may have to rely on more expensive trade credit to meet seasonal or growth requirements.

Liquidity and Short-Term Funding

Companies can boost their financial flexibility by crafting a short-term financing strategy and routinely evaluating available funding alternatives. Firms that neglect to thoroughly explore these options or capitalize on cost savings from existing forms of financing may encounter higher financing costs or even financial distress, where they find themselves incapable of borrowing from any source.

An astute short-term financing strategy, encompassing decisions on when and how to borrow, accomplishes several goals, such as:

• Ensuring enough and varied sources of credit to fund ongoing cash requirements.
• Obtaining sufficient financing capability to address the company’s evolving cash demands, which might encompass catering to peak seasonal requirements or anticipated expansion.
• Ensuring that the provided financing rates, along with their terms and conditions, are competitive and recognizing how these rates may vary in different capital market scenarios and economic climates.
• Making sure that both implicit costs, such as supplier financing costs and explicit funding expenses, are taken into account when determining the company’s actual borrowing cost.

Several factors will influence a company’s short-term borrowing strategies:

• Size: The size of a company plays a pivotal role in defining its financing options. For instance, privately-owned businesses might only have access to short-term credit boosts from one bank. In contrast, substantially larger firms can tap into short-term fixed-income markets in addition to other funding avenues.
• Creditworthiness: The credibility of a company not only dictates if a financial institution will grant a loan and the interest rate charged but also the terms and stipulations tied to the loan. A company with lesser creditworthiness might find lenders imposing conditions that limit its asset utilization in specific ways.
• Legal considerations: Companies operating in emerging markets, where legal frameworks might be less established, could face limited financing choices from financial intermediaries or markets compared to developed economies.
• Regulatory requirements: Certain industries, especially in developed markets, are subject to stringent regulations. For instance, banks or utilities might encounter restrictions in their borrowing amount or the nature of available borrowing options.
• Asset nature: Companies, based on their business model, might possess assets like inventory, which can be deemed valuable collateral for secured short-term loans.

Question

Which of the following factors will least likely influence a company’s short-term borrowing strategies?

1. Size and creditworthiness.
2. Legal and regulatory considerations.
3. Capacity to handle sudden cash needs.

Solution

The correct answer is C.

Ensuring the capacity to handle sudden cash needs is an objective of a short-term borrowing strategy.

A is incorrect. Size and creditworthiness are factors influencing a company’s short-term borrowing strategy. A company’s size influences the options at its disposal, while its creditworthiness influences the interest rate it will pay.

B is incorrect. Legal and regulatory considerations influence a company’s short-term borrowing strategy since there may be regulatory restrictions on the amount a company can borrow.