After establishing the level of current assets, the firm must determine how these should be financed. What mix of term capital and short term debt should the firm employ to support its current assets?
For the sake of simplicity assets are divided into two classes, viz. fixed assets and current assets. Fixed assets are assumed to grow at a constant rate which reflects the secular rate of growth in sales. Current assets, too, are expected to display the same long term rate of growth; however, they exhibit substantial variation around the trend line, thanks to seasonal (or even cyclical) patterns in sales and/or purchases.
The investment in current assets may be broken into two parts: permanent current assets and temporary current assets. The former represents what the firm requires even at the bottom of its sales cycle.
The latter reflects a variable component that moves in line with seasonal fluctuations.
Several strategies are available to a firm for financing its capital requirements. Three strategies are illustrated by lines A,B, and C below.
Strategy A: Long term financing is used to meet fixed asset requirement as well as peak working capital requirement. When the working capital requirement is less than its peak level, the surplus is invested in liquid assets (cash and marketable securities).
Strategy B: Long term financing is used to meet fixed assets requirement, permanent working capital requirement, and a portion of fluctuating working capital requirement. During seasonal swings, short-term financing is used during seasonal down swing surplus is invested in liquid assets.
Strategy C: Long term financing is used to meet fixed asset requirement and permanent working capital requirement. Short term financing is used to meet fluctuating working capital requirement.
The Matching Principle:
According to this principle, the maturity of the sources of financing should match the maturity of the assets being financed. This means that fixed assets and permanent current assets should be supported by long term sources of finance whereas fluctuating current assets must be supported by short term sources of finance.
The rationale for the matching principle is fairly straightforward. If a firm finances a long term asset (say, machinery) with a short term debt (say, commercial paper), it will have to periodically refinance the asset. Whenever the short term debt falls due, the firm has to re-finance the assets. This is risky as well as inconvenient. Hence, it makes sense to ensure that the maturity of the assets and the sources of financing are properly matched.
Operating cycle and cash cycle:
The investment in working capital is influenced by four key events in the production and sales cycle of the firm:
1. Purchase of raw materials
2. Payment of raw materials
3. Sale of finished goods
4. Collection of cash for sales
The firm begins with the purchase of raw materials which are paid for after a delay which represents the cost payable period. The firm converts the raw material to finished goods and then sells the same. The time lag between the purchase of raw materials and the sale of finished goods is the inventory period. Customers pay their bills sometimes after the sales. The period that elapses between the date of sales and the date of collection of receivables is the accounts payable period (debtors period).
The time that elapses between the purchase of raw materials and the collection of cash for sales is referred to as the operating cycle, whereas the time between the payment for raw materials purchases and the collection of cash for sales is referred to as the cash cycle. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less, the accounts payable period.
From the financial statements of the firm, we can estimate the inventory period, the accounts receivable period, and the accounts payable period.