Page 224 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 10.5.1 Current Assets in Relation to Sales

If the firm can free cash accurately its level and pattern of sales, inventory procurement time,
inventory usage rates, level and pattern of production, production cycle time, split between cash
sales and credit sales, collection period and other factors which imprenge on working capital
components. The investment in current assets can be defined uniquely. When uncertainty
characterizes the above factors, as it usually does, the investment in current assets cannot be
specified uniquely. In face of uncertainty, the outlay on current asset would consist of a base
component meant to meet normal requirements and safety component meant to cope with
unusual demands and requirements. The safety component depends on how conservative or
aggressive is the current asset policy of the firm. If the firm pursues a very conservative current
asset policy, it should carry a high level of current assets in relation to sales. (This happens
because the safety components are substantial). If the firm adopts a moderate current asset
policy, it should carry a moderate level of current assets in relation to sales. The relationship
between current assets and sales under these current asset policies is shown in Figure
Figure 10.3: Various current assets policies

Conservative
Moderate
Current assets

Aggressive

A conservative current asset policy tends to reduce risk. The surplus current assets under this
policy enable the firm to cope rather easily with variations in sales, production plans and
procurement time. Further the higher liquidity associated with this policy diminishes the chances
of technical insolvency. The reduction of risk is also accompanied by lower expected profitability.
An aggressive current asset policy, seeking to maximize the investment in current assets, exposes
the firm to greater risk. The firm may be unable to cope with anticipated changes in the market
place and operating conditions. Further, the risk of technical insolvency becomes greater. The
compensation for higher risk, of course, is the higher expected profitability.

10.5.2 Ratio of Short-term Financing to Long-term Financing

Working capital requirements should be met from short term as well as long-term sources of
funds. It may be proper to meet at least 2/3rd of the permanent working capital from long-term
sources.

Long-term funds reduce the risk but are costly. On the other hand, short-term funds have relatively
lower cost but need to be repaid in the near future. Hence the finance manager has to make
judicious use of both long-term and short-term sources. In this context, there are three basic
approaches:

Marketing Approach (Hedging Approach)

When a firm uses long-term sources to finance fixed assets and permanent current assets and
short term financing to finance temporary current assets.

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