Working Capital Management: Funding and Financing
Policy Coverage in Working Capital Management
Funding requirements, from the point of view of temporality, have the following classification:
- Permanent: The resources at all times of operation of the business are needed. Their absence means significantly altering the nature of operations.
- Temporary: These are, by their nature, flexible and can be reduced according to seasonal needs or decisions taken by the administration.
The hedging policy establishes the criteria that permanent needs be funded long-term (long-term liabilities or equity) and temporary or seasonal needs with short-term funds (liabilities), such as suppliers, documents or accounts payable, and bank loans. Graphically, this policy is given as:
Working Capital Financing Without Seasonality
Suppose you are analyzing a company that shows no seasonality in their production and sales cycles, which is why the working capital needed for its operation presents no seasonality. Would you recommend that, given this condition, working capital financing is solely from long-term liabilities?.
Justification:
In this situation, it cancels one of the features found in short-term financing, which is to be able to do without it when the seasonality of operating permits. However, it would be if the explicit cost of alternative short-term financing is cheaper than the long-term. This lower cost can be determined eventually by lower interest rates or no-cost funding sources, as in some cases with suppliers. In conclusion, one cannot define “a priori” a rule like the one mentioned in the question, but rather the situation must be studied in each case and decided according to risk and return parameters, the latter being determined, in this case, for liquidity risk.
Financial Cost: Short-Term vs. Long-Term
Clearly and neatly explain the underlying reasons or financial theory to say that the financial cost of short-term explicit is less than the long-term.
Explicit cost means the sum total of the costs of a funding source, such as interest rates, required to maintain certain balances, levels, minimum purchase risk, recourse to financing urgent unscheduled, and so on.
In this sense, it is explicit that the cost is lower due to three reasons:
- Interest Rate: Interest rates generally required by lenders are lower for the short term than for the long term. This is because the risk component that adds the time makes it more expensive.
- Flexibility of short-term financing: This type of financing, for its feature, can be reduced and increased according to the cyclical needs, thus allowing the company to waive it in the times or periods that do not.
- Existence of low-cost sources: There are some alternatives, depending on the industry that is inserted in the company, which have low or no cost. This is the case of some suppliers; favoring the sale, they are ready to grant terms of payment without penalty. In this case, we must be careful because if these vendors offer a discount for prompt payment, the source in question begins to take charge immediately because if we decide to use the credit, we are giving the discount, which would represent the cost, he is generally significant.