Working capital policies are associated with the decisions that finance managers make regarding the current asset and liability levels that are set to carry out the operations of the company. These levels have a direct impact on the risk-return profitability binomial. Based on the above, the article explains the bases that support the association of current asset and liability levels with operating levels, the content of each of the working capital policies: investment and short-term financing. term, as well as their impact on the risk-return alternative.
Development
The working capital policies are associated with the levels of assets and current liabilities that are set to carry out the operations of the company, taking into account their interrelation, as well as with the operating levels, so that three fundamental elements can be categorized into this sense (L. Gitman, 1986; F. Weston and E. Brigham, 1994; Van Horne and Wachowicz, 1997 and E. Santandreu, 2000):
- Target level set for each category of current assets: current investment policy. The way these current assets will be financed: current financing policy. The effects of these levels on the risk-return binomial.
There is a close relationship between investment, financing and company operations, a fundamental aspect in understanding working capital policies, for which, before establishing the theoretical elements related to them and their influence on risk and profitability, it is necessary to establish the bases that support the problem of associating current asset and liability levels with operating levels.
- Weston and E. Brigham (1994), in their effort to establish methods for financial forecasting, refer to relationships, two of them relevant in this framework: the first, between sales and investment in current assets, and the second, between sales and spontaneous financing. The first relation this author defines as causality, since the sales demand is the cause of the investment in inventories, accounts receivable and the maintenance of cash. On the other hand, it defines the importance of stability to achieve forecasts closer to reality. In his model for calculating the EFR or Requirement for External Funds, this author shows a linear relationship between sales and accounts receivable and inventories assuming the growth of spontaneous funds and current assets,in direct relation to sales, thus assuming linearity in two relations: 1) sales - current assets and 2) sales - spontaneous financing.
For their part, Van Horne and Wachowicz (1997) recognize these relationships, but also the inconsistency of stable growths. Regarding the above, he explains that for each level of sales, different levels of current assets and liabilities can be established. Likewise, for each level of current assets, different levels of current liabilities can be established, which gives way to investment policies and short-term financing.
Short-term investment policies and their influence on risk and profitability .
Short-term investment policies are associated with decisions made about the levels of each of the current assets in relation to the sales levels of the company. According to Van Horne and Wachowicz (1997), different levels of current assets may correspond to each level of sales, which graphically is as shown in Figure 1a).
The policies that can be implemented as a result of the above can be classified as: relaxed or conservative, restricted and moderate (F. Weston and E. Brigham, 1994 and Van Horne and Wachowicz, 1997), which are discussed below.
The relaxed or conservative policy is a policy under which high levels of current assets are ensured. With it, the company is considered prepared for any eventuality, maintaining relatively large amounts of cash and inventories and through which, sales are stimulated through a liberal credit policy, resulting in a high level of accounts receivable. In Figure 1a), curve A is the exponent of this policy. As a result of the application of this policy, the liquidity will be higher and therefore the risk of insolvency will be lower, as well as the profitability lower.
For its part, the restricted or aggressive policy is a policy under which the maintenance of cash, inventories and accounts receivable is minimized; that is, relatively small amounts of circulating assets are held. As a consequence of this policy, the risk and profitability of the company will be high. This policy in Figure 1a) corresponds to curve C.
Figure 1: Investment policies in current assets and their impact on risk and profitability.
| a) Investment policies in current assets. | b) Impact on risk and profitability. |
| Source: Espinosa, Daisy. Proposal for a procedure for the analysis of working capital. Hotel case. Thesis presented as an option to the scientific degree of Master in Economic Sciences, directed by Dr. Nury Hernández de Alba Álvarez. University of Matanzas, 2005. |
The moderate or intermediate policy, however, is between the relaxed policy and the restricted policy, where the high levels of risk and profitability are compensated by their low levels. In Figure 1a), curve B corresponds to this behavior.
In general, the impact on the risk and profitability of the policies can be emphasized, as shown in Figure 1b).
All of the above leads to internalize that when determining the appropriate amount or level of current assets, the analysis of working capital must consider the compensation between profitability and risk, where the higher the level of current assets, the greater the liquidity of the company., if everything else remains constant; Likewise, with greater liquidity, the risk is lower, but so will the profitability.
Importantly, for each level of performance, a minimum level of current assets can be maintained to enable successful business operations.
Decreasing the level of investment in current assets while still being able to sustain sales can lead to an increase in the company's return on total assets. On the other hand, an increase in current assets values above the necessary optimum, would result in an increase in total assets, without a proportional increase in returns, thus decreasing the return on investment. A decrease in these values may mean the inability to cover payments on time, stops in the production process due to lack of inventory and a decrease in sales due to an inflexible credit policy.
Short-term financing policies and their influence on risk and profitability .
It is important to take all necessary measures to determine a financial structure, where all current liabilities effectively and efficiently finance current assets and the determination of optimal financing for the generation of profit and social welfare. A level of sales that grows uniformly over the years will necessarily produce increases in current assets (F. Weston and E. Brigham, 1994; Van Horne and Wachowicz, 1997 and E. Santandreu, 2000). To the extent that current assets experience variations, the financing of the company will also do so, affecting the risk and working capital position of the company. Hence the importance of determining how the company finances its fluctuating current assets. Thus,The current investment financing policies are: aggressive, conservative and self-liquidation or maturity coordination. These policies are explained below.
The aggressive or compensatory policy provides that the company finances all its fixed assets with long-term capital, but also that it finances a part of its permanent current assets with short-term funds of a non-spontaneous nature (F. Weston and Brigham, 1994). This position is aggressive since the company would be subject to great dangers arising from the increase in interest rates, as well as to various loan renewal problems. However, since short-term debt is generally cheaper than long-term debt, assuming this policy is associated with the willingness to sacrifice security in the face of the opportunity to obtain higher profits. This is a policy of high levels of risk and return (L. Gitman, 1986 and F. Weston and E. Brigham, 1994).
In a conservative policy situation, permanent capital is used to finance all permanent asset requirements and satisfy some or all of the seasonal demands. In applying this policy, the company uses a small amount of short-term, non-spontaneous credit to satisfy its highest levels of requirements, but it also satisfies part of its seasonal needs by “storing liquidity”. It consists of the use of long-term capital to finance all permanent assets and some temporary current assets, which denotes low levels of risk and profitability.
For its part, the policy of self-assessment or coordination of maturities requires that the maturities of current assets and liabilities be coordinated. This strategy minimizes the risk that the company is unable to settle its obligations as they mature, trying to coordinate the exact maturity structure of its assets and liabilities. This policy seeks a balance between risk and return levels (F. Weston and E. Brigham, 1994).
Figure 2: Current financing policies and their impact on risk and profitability.
Source: self made.
The three policies described above and their impact on risk and profitability can be seen in Figure 2. These are distinguished by the relative amounts of short-term debt. Aggressive policy requires greater use of short-term, non-spontaneous debt, while conservative policy requires the minimum of these resources, while maturity coordination takes into account an intermediate point.
In general, to the extent that the explicit costs of short-term financing are lower than medium and long-term financing, that is, the greater the ratio of short-term debt to total debt, the higher the profitability of the business.
Even though short-term debt is often less expensive than long-term debt, short-term credit subjects the business to greater risk than long-term financing. This occurs for two fundamental reasons.
- If the company borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expenses will fluctuate widely, occasionally becoming very high. borrowing large amounts on a short-term basis, you may find that you are unable to repay your debts, and you may also be in such a weak financial position that the lender refuses to extend more credits; This could also lead to bankruptcy.
Conclusions
In summary, the risk and return assumptions that have been exposed suggest a low ratio of current assets to total assets and a high ratio of current liabilities to total liabilities. Of course, this strategy will result in a low level of working capital. However, offsetting the profitability of this strategy is the increased risk for the company.
Bibliography
- Thorny, Daisy. Proposal for a procedure for the analysis of working capital. Hotel case. Thesis presented as an option to the scientific degree of Master in Economic Sciences, directed by Dr. Nury Hernández de Alba Álvarez. Universidad de Matanzas, 2005. Gitman, L. Foundations of Financial Administration. Special edition. Ministry of Higher Education. Cuba, 1986. Weston, F. and E. Brigham. Fundamentals of Financial Administration. McGraw Hill Publishing. 10th Edition. Spain, 1994. Weston, F and T. Copeland. Administration finance. McGraw Hill Publishing. 9th Edition. Mexico, 1995. Van Horne, Wachowicz. Fundamentals of financial administration. 8th edition. Prentice Hall Hispanoamericana. 1997.Santandreu, E. Business finance management. Ediciones Gestión 2000. Spain, 2000.
F. Weston and E. Brigham. Fundamentals of financial administration. 1994.
From the English term: External funds required.
In reality there are two factors that are responsible for avoiding an exact coordination of maturities. The first is the existence of uncertainty in the life of the assets and the second is that some common stock capital resources must be used and these resources do not have expiration dates (F. Weston and Brigham, 1994).
Although short-term interest rates are sometimes higher than long-term rates, they are generally lower - otherwise it may be a temporary situation. Over an extended period of time, we should expect to pay more for interest costs on long-term debt than we would for short-term loans, which are continually renewed at maturity.
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