The current assets of a typical manufacturing firm account for over half of its total assets. For a distribution company, they account for even more. Excessive levels of current assets can easily result in a firm realizing a substandard return on investment. However, firms with too few current assets may incur shortage and difficulties in maintaining smooth operations.
For small companies, current liabilities are the principal source of external financing. These do not have access to the longer term capital markets capital markets, other than to acquire a mortgage on a building. The fast growing but larger company also makes use of current liability financing. For these reasons, the financial manager and staff devote a considerable portion of their time to working capital matters. The management of cash, marketable securities, accounts receivable, accounts payable, accruals, and other means of short-term financing is the direct responsibility of the financial manager; only the management of inventories is not. Moreover, these management responsibilities require continuous day-to-day supervision. Unlike dividend and capital structure decisions, you cannot study the issue, reach a decision, and set the matter aside for many months to come. Thus, working capital management is important, if for no other reason than the proportion of the financial managerâ€™s time that must be devoted to it. More fundamental, however, is the effect that working capital decisions have on the companyâ€™s risk, return, and share price.
Profitability and Risk:
Underlying sound working capital management lie two fundamental decision issues for the firm. They are the determination of,
1. The optimal level of investment in current assets.
2. The appropriate mix of short-term and long-term financing used to support this investment in current assets.
In turn, these decisions are influenced by the trade-off that must be made between profitability and risk. Lowering the level of investment in current assets, while still being able to support sales, would lead to an increase in the formâ€™s return on the total assets. To the extent that the explicit costs of short-term financing are less than those of intermediate and the long-term financing, the greater the proportional of short-term debt to total debt, the higher is the profitability of the firm.
Although short-term interest rates sometimes exceed long term rates, generally they are less. Even when short-term rates are higher, the situation is likely to be only temporary. Over an extended period of time, we would expect to pay more in interest cost with long-term debt than we would with short-term borrowings, which are continually rolled over (refinanced) at maturity. Moreover, the use of short-term debt as opposed to longer-term debt is likely to result in higher profits because debt will be paid off during periods when it is not needed.