A basic policy decision in the administration of Working Capital is the choice between the uses of short or long-term financing. The choice between the two forms of indebtedness involves an analysis of flexibility, costs and risks of each of these forms. Short-term financing decisions influence the cash level that will be maintained.
The amounts that a company can obtain borrowed and other providers of short – term funds generally have a limit. Of course, our short-term situation, which will be reflected in the current ratio, the liquidity ratio and other measures discussed in the previous chapter, will indicate the importance of such restrictions on our cash management. Frequently, restrictions on a certain type of financing are related to other sources of funds. For example, large corporations they can issue unsecured, short-term notes, called commercial documents, as long as these issues are backed by complementary credit agreements with the deposit banks.
Interest rates are smaller on short-term debt than on long-term debt. However, a borrower who uses long-term debt avoids the uncertainty of fluctuating short-term rates and the possibility of having to renew debt under adverse conditions in the money and capital markets. Many current liabilities suggest the use of commercial credit, which is as convenient as it is flexible, and the use of other spontaneous circulating liabilities. In addition, long-term can be used because they often provide the advantage of flexibility in meeting the fluctuating needs of funds at a low cost. But nevertheless, excessive use of short-term debt implies a considerable degree of risk. The cash flow cycle is determined by three basic liquidity factors:?
- The inventory conversion period.
- The period of conversion of accounts receivable.
- The deferral period of accounts payable.
The first two indicate the amount of time during which the current assets of the company are frozen; the third indicates the amount of time during which the company will use the funds of the suppliers before they require payment for the acquisitions.
Management decisions of Working Capital require an understanding of the structure of terms of interest rates, which is the relationship between the levels of interest rates and the maturity of the loans. Changes in the economy and in government policies affect the supply and demand of funds, and cause cyclical fluctuations. When the conditions of money markets are narrow, short-term rates are often above long-term rates, but when the conditions of money markets are relaxed or in a state relatively normal, short-term rates are generally below long-term rates. These interest rate ratios have important implications for the financing of Working Capital requirements.
There are 2 positions within short-term financing decisions, one that says that: “Current assets must be financed with current liabilities” and “Fixed assets must be financed with fixed liabilities”, which is the liberal decision, which it is very risky since you work with foreign capital. On the other hand, there is the conservative decision: Both the current assets and the current liabilities are financed with funds from the fixed liability, serving only the liability for emergencies.
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