Choosing a financing strategy for current assets
The company's net working capital determines the level of liquidity of its balance sheet and the efficiency of using current assets. Therefore, any changes in the composition of its constituent elements (current assets and liabilities) affect the amount of net working capital. The acceptable growth of its volume is considered as a positive trend in the activity of the enterprise (corporation). However, there may be exceptions to this rule. For example, the growth of net working capital due to bad debts will not suit a financial manager.
One of the elements of current assets is inventories. The storage costs are related not only to storage costs, but also to the risk of deterioration and obsolescence of products, as well as the alternative cost of capital, i.e. with a rate of return that can be obtained as a result of another investment of funds with an equivalent degree of risk (investments in securities, currency, real estate, etc.) •
Another important element of current assets is accounts receivable. When one enterprise sells goods to another enterprise, this does not mean that the product will be paid immediately. Unpaid invoices for goods delivered (or accounts receivable) constitute the bulk of accounts receivable. Therefore, one of the key problems in the management of accounts receivable is the determination of the insolvency risk of customers (customers), the calculation of the forecast value of the provision for bad debts, and the work on collecting debts.
Cash and funds of easy-to-sell securities are the most liquid part of current assets. The financial manager always faces the task of choosing the optimal ratio between cash and investments in short-term securities. On the one hand, there are advantages associated with the formation of an acceptable cash reserve: this reduces the risk of shortage of cash to meet the priority requirements of creditors. On the other hand, the cost of keeping temporarily free cash is much higher than the costs associated with investing money in short-term securities. They can be conditionally estimated in the amount of unearned profit with possible short-term investments (in the form of interest, discount, etc.).
Current liabilities include short-term loans, loans and payables, primarily in settlements with suppliers and contractors. As a rule, banks require documentary confirmation of the security of the requested loans by the real property of the borrower. When calculating with creditors, such collateral is not required. Thus, some enterprises can solve short-term financing problems by pledging existing real assets, others - at the expense of their implementation, leasing, etc. Short-term liabilities can not be sources of coverage of non-current assets. If the value of net working capital is zero, the risk of losing liquidity reaches a maximum, and as the value of this indicator increases, the risk of loss gradually decreases. If the short-term debt is zero, the net working capital reaches the maximum value and will be equal to the value of the current assets. In this case there is no risk of liquidity loss.
In the theory of financial management, it is customary to distinguish between inadequate strategies for financing current assets based on the ratio of the financial manager (manager) to choosing sources of coverage for their mobile part.
There are several models of behavior in the management of current assets: ideal , aggressive, conservative and moderate.
The choice of the model is reduced to determining the volume of long-term liabilities and the calculation of net working capital on its basis:
PSC = DP - BOA,
where PSC is the net working capital; DP - long-term liabilities, including own sources and long-term liabilities; BOA - non-current assets.
Each financial manager's behavior strategy has its own balance equation.
The ideal model short-term financing is built on the economic nature of current assets and short-term obligations, their mutual compliance. This model assumes that current assets coincide in value with short-term liabilities, and net working capital is zero (PSC = 0).
In real economic life, such a model is practically not found. From the position of liquidity, it is the most risky, since under unfavorable conditions (if necessary, pay with all creditors at a time), the enterprise may face the need to sell part of its fixed assets to pay off short-term liabilities.
The content of this strategy is that long-term liabilities are set at the level of non-current assets, i.e. the model has the form
ДП = ВОА - ЧОК = 0,
where the DP - long-term (fixed) liabilities (DP + SK); VOA - non-current (capital) assets; PSC - net working capital.
Other models of management of circulating assets are more real. They are based on the assumption that to ensure the liquidity of an enterprise, non-current assets and a stable (constant) portion of current assets should be recovered from long-term liabilities:
BOA + SC = DP,
where BOA - non-current (capital) assets; MF - stable (constant) part of current assets; DP-long-term (fixed) liabilities (DP + SK).
Therefore, the difference between models is what sources of financing are chosen to cover the variable (variable) part of the current assets.
Aggressive model means that long-term liabilities serve as a source of coverage of non-current assets and a stable part of current assets, i.е. their minimum, which is necessary for the implementation of the current activities of the enterprise. In this case, the net working capital is equal to this minimum:
PSC = MF,
where PSC - net working capital; MF - stable (constant) part of current assets.
The variable part of the current assets is fully covered by short-term debt. From the liquidity position, this model is very risky, since in real life it's very difficult to limit only to a minimum of current assets. The balance equation can be expressed by the following formula:
ДП = ВОА + СЧ,
where the DP - long-term (fixed) liabilities (DP + SK); VOA - non-current (capital) assets; MF - stable (constant) part of current assets.
The conservative model assumes that a variable proportion of current assets is also covered by long-term liabilities. In this case there is no short-term debt, therefore there is no risk of liquidity loss:
PSC = OA,
where PSC - net working capital; OA - current assets.
This model is of an artificial nature and involves the establishment of long-term liabilities at the level determined by the following balance equation:
AP = VOL + сч + вч,
where the DP - long-term (fixed) liabilities (DP + SK); VOA - non-current (capital) assets; MF - stable (constant) part of current assets; HF - variable (variable) part of current assets.
A moderate (compromise) model is the most viable. When it is used, non-current assets, a stable part of current assets and approximately 50% of a variable portion of current assets are covered by long-term liabilities. Net working capital is equal to the value of the stable part of current assets and half of their variable part and is calculated by the formula
PSC = MF + 0.5 x HF,
where PSC - net working capital; MF - stable (constant) part of current assets; HF - variable (variable) part of current assets.
In some periods of the life cycle, an enterprise may have excess current assets, which adversely affects the amount of profit due to the need to pay property tax. However, this fact is considered as a fee for maintaining the risk of loss of liquidity at an acceptable level, which allows to maintain normal solvency. A moderate strategy involves setting long-term liabilities at the level determined by the following balance equation:
ДП = BАА + СЧ + 0,5 х HF,
where the DP - long-term (fixed) liabilities (DP + SK); VOA - non-current (capital) assets; MF - stable (constant) part of current assets; HF - variable (variable) part of current assets.Therefore, the choice of the appropriate model of management of current assets depends on the position of the enterprise (corporation) in the commodity market, its financial stability, the qualifications of financial managers and other factors of an objective and subjective nature.
Also We Can Offer!
- Argumentative essay
- Best college essays
- Buy custom essays online
- Buy essay online
- Cheap essay
- Cheap essay writing service
- Cheap writing service
- College essay
- College essay introduction
- College essay writing service
- Compare and contrast essay
- Custom essay
- Custom essay writing service
- Custom essays writing services
- Death penalty essay
- Do my essay
- Essay about love
- Essay about yourself
- Essay help
- Essay writing help
- Essay writing service reviews
- Essays online
- Fast food essay
- George orwell essays
- Human rights essay
- Narrative essay
- Pay to write essay
- Personal essay for college
- Personal narrative essay
- Persuasive writing
- Write my essay
- Write my essay for me cheap
- Writing a scholarship essay