Management Decisions
6.2 Approaches to Working Capital Management
In the last section, we discussed the tradeoff that managers face in their working capital management decisions. Managers must maintain sufficient liquidity to ensure the firm can meet its maturing short-term obligations. On the other hand, excessive investment in current assets enhances liquidity but lowers profitability and reduces shareholder wealth.
Managers have different philosophies or approaches for handling this risk-return relationship in working capital management. A relaxed or conservative approach is one that relies on greater levels of current assets; a restricted or aggressive approach relies much less heavily on investments in cash, marketable securities, and inventories. A moderate approach falls between these two. Figure 6.1 illustrates these three approaches.
Working capital management approaches also vary in terms of how the firm finances seasonal variations in current assets. Three common approaches include the maturity- matching approach, the conservative approach, and the aggressive approach. If sales were constant throughout the year, a firm’s investment in current (operating) assets would be constant and the firm would only have a permanent funding requirement. With cyclical sales, however, current assets vary with the sales cycle, and the firm has both seasonal and permanent funding requirements. The maturity-matching, conservative, and aggressive approaches represent different philosophies about how to finance the seasonal variations in current assets. We discuss each approach below.
160 WORKINGCAPITALMANAGEMENTDECISIONS
Maturity-matching Approach
As its name suggests, the maturity-matching approach involves hedging risk by matching the maturities of a firm’s assets and liabilities. Under this approach, the firm finances long- term assets (fixed assets and permanent current assets) with long-term financing sources (long-term debt and equity). The firm finances seasonal variations in its current assets with current liabilities that have the same maturity. By matching the level of short-term financing to the level of temporary current assets, the firm hedges against unexpected changes in short-term interest rates. Any increases (decreases) in short-term interest rates that raise (lower) the cost of short-term financing will be offset by increases (decreases) in the return earned on an equal amount of short-term current assets. Figure 6.2 illustrates the maturity- matching approach.
Conservative Approach
Under the conservative approach for managing working capital, the firm uses long-term funds to finance its long-term assets, all permanent current assets, and some temporary current assets. Thus, the firm uses short-term financing for only some of the temporary cur- rent assets. Why is this a conservative approach? Short-term funds are usually less expens- ive than long-term funds because the yield curve is typically upward sloping. Thus, when the firm uses more long-term funds, it can lock in its cost of funds and avoid increases in short-term rates. In addition, by locking in more long-term sources of financing, the firm protects itself against the risk of a credit shutoff if either general economic conditions or the company’s financial condition worsens.
Figure 6.3 depicts the conservative approach. An important point to note is that when the need for temporary current assets is low, the firm’s long-term financing will exceed its total assets. During such periods, the company will invest excess funds in marketable securities.
Relaxed
Moderate
Restricted
Sales ($) Current
assets ($)
Figure 6.1 Approaches to working capital management
$
Temporary current assets
Short-term financing
Long-term financing
Time Fixed assets
Permanent current assets
Figure 6.2 Maturity-matching approach for managing working capital
Figure 6.3 Conservative approach for managing working capital
Aggressive Approach
The aggressive approach for managing working capital involves using more short-term financing and less long-term financing than in the maturity-matching and conservative approaches. As shown in Figure 6.4, the firm uses short-term financing for all temporary current assets and for some of its permanent current assets. This approach is aggressive in
$
Temporary current assets
Marketable
securities Short-term financing
Long-term financing
Time Fixed assets
Permanent current assets
162 WORKINGCAPITALMANAGEMENTDECISIONS
$
Temporary current assets
Short-term financing
Long-term financing
Time Fixed assets
Permanent current assets
the sense that the firm will be less than hedged against changes in short-term interest rates.
By financing some of its permanent current assets with short-term financial instruments, the firm will face an increased cost of financing if short-term interest rates rise. Of course, the firm would benefit from any declines in short-term rates.
Several factors may affect the approach that a firm chooses for managing its working capital. A firm without ready access to capital markets may choose the conservative ap- proach and employ more long-term financing. If short-term interest rates rise, the firm will have less to refinance at the higher rates and can avoid the risk of credit being shut off by suppliers. On the other hand, a manager who believes that short-term interest rates will fall may be tempted to adopt the aggressive approach. If the manager’s prediction is correct, the firm will have more funds to refinance at the lower rates in the near future. By hedging against changes in interest rates, the maturity-matching approach allows managers to con- centrate on other more important value-maximizing decisions.
Concept Check 6.2
1 What are the similarities and differences among the maturity-matching, conserva- tive, and aggressive approaches for managing working capital?
2 How would an increase in short-term interest rates affect a firm under the con- servative, maturity-matching, and aggressive approaches to managing working capital?
Figure 6.4 Aggressive approach for managing working capital