Top 3 Factors for Financing Current Assets | Working Capital

This article throws light upon the top three factors for financing current assets. The factors are: 1. Flexibility 2. Risk 3. Cost of Financing.

Financing Current Asset: Factor # 1. Flexibility:

It is comparatively easy to repay short-term loans than long-term ones when the need for funds decreases. Long-term funds, e.g., debenture or preference share capital cannot be redeemed before time. Therefore, when the need for finance is of seasonal/ fluctuating nature, short-term sources (for financing current assets) will be more advantageous than long-term ones from the standpoint of flexibility.

Financing Current Asset: Factor # 2. Risk:

Short-term financing, no doubt, involves less cost, but at the same time more risky than long-term ones due to the following:

(i) Interest cost on short-term borrowings may fluctuate widely whereas interest on long-term borrowings is more stable.

(ii) Continued financing from short-term sources exposes the firm unable to repay its short-term debts which adversely impacts on the credit reputation of the firm. In future, the firm may be unable to raise any funds since the lenders will be reluctant to extend loans and consequently, its operating activities may be disrupted.

Therefore, it is better to use long-term funds than short-term funds for financing current assets. At least, the fixed/permanent current assets should be financed from long-term sources in order to avoid risk.

Risk-return trade-off:

From the above, it is quite clear that short-term financing is less expensive than long-term financing but the former involves greater risk than the latter. So, the choice between long-term and short-term financing relates to trade-off between risk and return. The following illustration will make the principle clear.

Illustration:

(a) Total investments:

(b) Earning (EBIT) is 12%.

(c) Debt-ratio is 60%.

(d) Rs. 80,000 being 40% assets is financed by the equity shareholders, i.e., long-term sources.

(e) Cost of short-term debt and long-term debt is 7% and 8% respectively.

(f) Assume Income-tax @ 50%.

As a result of the financing policy, ascertain the return on equity shares.

Solution:

It is evident from the above table that the return on equity shares differs under different policies. It is the highest in the case of aggressive policy and lowest in the case of conservative policy. Since the ratio of short-term debt to total assets is higher in the case of aggressive policy, the risk is also great and in the opposite case, there is no risk.

Financing Current Asset: Factor # 3. Cost of Financing:

In developed countries, the rate of interest is related to the maturity of debt. The relationship between maturity of debt and its cost, (i.e., yield and maturities), is known as the term structure of interest rates. The curve which shows the above relationship with the help of a graph is termed as yield curve.

It may be either upward sloping, or downward sloping or flat. But generally, it shows an upward sloping which indicates that rate of interest increases with time and if the maturity of debt is longer, the rate of interest also will be greater.

Long-term financing cost depends, however, on the following factors:

(i) Liquidity or risk preferences of lenders and borrowers — liquidity preference theory;

(ii) Supply and demand conditions in the money market, and

(iii) Expectations about future interest rates.

It has been repeatedly discussed above that short-term sources are less expensive than long-term since short-term sources involve greater degree of risk from the standpoint of risk preferences. As such, the lenders will prefer short-term financing. But they will be interested in long-term lending provided the rate of interest is higher.

Similarly, borrowers also will prefer long-term loans in order to avoid the risk of renewal of short-term sources on a continued basis. Therefore, lenders and bor­rowers are ready to pay low rates on short-term sources and high rates on long-term sources.

Demand-supply condition also has an impact on cost of financing. If, at a par­ticular time, it is found that the demand is heavier in the short-term market but the supply is abundant in the long-term, naturally, this will tend to increase a higher cost for short-term sources and a lower cost for long-term ones.

Expectations about future interest rates affect the yield curve. In other words, if the rate of interest is expected to rise in near future, the lender will prefer short-term lending than the long-term lending for the benefits of increased rates. It will be reversed in the opposite case.

From the standpoint of return, short-term financing is desirable since it is less costly and the return will relatively be higher. On the other hand, long-term financing is more costly and the rate of return on equity will also be higher.

The relative liquidity structure of the firm’s assets and financial structure can be measured respectively by the:

(i) Current Assets/Fixed Assets or. Current Asset/Total Assets Ratio:

The higher the ratio, there will be less risky and less profitable position of the firms and vice-versa.

(ii) Short-Term Financing/Total Financing Ratio:

The lower the ratio, there will be less risky and less profitable position of the firm and vice-versa.

In short, the above two dimensions — relative assets liquidity and relative financ­ing liquidity — should be kept in mind by the firm before ascertaining its working capital position. A firm may adopt a very conservative working capital policy if it combines a high level of current assets along with a high level of long-term financing which, in other words, will be less profitable but the same will not be risky.

On the other hand, a firm may adopt the opposite policy also which involves greater degree of risk and there will be a high profitability. However, in the field of working capital management, the consideration of assets and financing mixes play a significant role.