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Friday, September 20, 2013

Alternative Current Asset Financing Policies



Most businesses experience seasonal and/or cyclical fluctuations. For example, construction firms have peaks in the spring and summer, retailers peak around Christmas and the manufacturers who supply both construction companies and retailers follow similar patterns. Similarly, virtually all businesses must build up current assets when the economy is strong. but they than see off inventories and reduce receivables when the economy slacks off. still, current assets rarely drop to zero-companies have some permanent current assets, which are the current assets on hand at the low point of the cycle. Then, as sales increase during the upswing, current assets must be increased and these additional current assets are defined as temporary current assets. The manner in which the permanent and temporary current assets are financed is called the firm’s current asset financing policy.

Maturity Matching, or “Self-Liquidating”, Approach

The maturity matching, or “self-liquidating”, approach calls for matching asset and liability maturities as shown in Panel a of Figure 17-1. This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations. To illustrate, suppose a company borrows on a one year basis and uses the funds obtained to build and equip a plant. Cash flows from the plant (profits plus depreciation) would not be sufficient to pay off the loan at the end of only one year, so the loan would have to be renewed. If for some reason the lender refused to renew the loan, then the company would have problems. Had the plant been financed with long-term debt, however, the required loan payments would have been better matched with cash flows from profits and depreciation, and the problem of renewal would not have arisen.

At the limit, a firm could attempt to match exactly the maturity structure of its assets and liabilities. Inventory expected to be sold in 30-days could be financed with a 30-day bank loan; a machine expected to last for 5-years could be financed with a 5-year loan; a 20-year building could be financed with a 20-year mortgage bond; and so forth. Actually of course, two factors prevent this exact maturity matching: (1) there is uncertainty about the lives of assets, and (2) some common equity must be used and common equity has no maturity. To illustrate the uncertainty factor, a firm might finance inventories with a 30-day loan, expecting to sell the inventories and then use the cash to retire the loan. But if sales were slow, the cash would not be forthcoming, and the use of short-term credit could end up causing a problem. Still if a firm makes an attempt to match asset and liability maturities, we would define this as a moderate current asset financing policy.

Aggressive Approach

Panel b of Figure 17-1 illustrates the situation for a relatively aggressive firm which finances all of its fixed assets with long-term capital and part of its permanent current assets with short-term, nonspontaneous credit. Note that we used the term “relatively” in the title for panel b because there can be different degrees of aggressiveness. For example, the dashed line in panel b could have been drawn below the line designating fixed assets, indicating that all of the permanent current assets and part of the fixed assets were financed with short-term credit; this would be a highly aggressive, extremely nonconservative position and the firm would be very much subject to dangers from rising interest rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-term debt, and some firms are willing to sacrifice safety for the chance of higher profits.

Conservative Approach

Panel c of Figure 17-1 has the dashed line above the line designating permanent current assets indicating that permanent capital is being used to finance all permanent asset requirements and also to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-term, nonspontaneous credit to meet its peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of marketable securities. The humps above the dashed line represent short-term financing, while the troughs below the dashed line represent short-term security holdings. Panel c represents a very safe, conservative current asset financing policy.

Chrysler, which in 1996 had $8.7 billion of cash and marketable securities, fits the panel c pattern. Its chairman, Robert Eaton, stated that these liquid assets will be needed during the next recession and he cited as evidence the fact that Chrysler had an operating cash deficit of more than $4 billion during the 1991-1992 recession. However, some of Chrysler’s could borrow funds in the future if need be, so the extra $6.7 billion should be redeployed to earn more than the 3 percent after taxes it was getting. The Chrysler example illustrates the fact that there is no clear, precise answer to the question of how much cash and securities a firm should hold.

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