Assignment 2: Question 2
Working capital management looks at the relationship between a firm's short-term assets and its short-term liabilities. The main goal of working capital management is to ensure that a firm has adequate cash flow for their operations and has the most productive use of their resources. Net working capital is the excess of current assets over current liabilities. Since current assets can be financed by either current liabilities or long term funds, the excess of current assets must be financed by long term funds.
There are 2 main sources of funds for working capital management and they are current liabilities and long term funds. Current liabilities are a cheaper source of funds than long term funds. The level of working …show more content…
All these three strategies are different because of their various trade-offs between risk and profitability and their proportion of application of long term fund and short term fund to finance the working capital.
First, we’ll look at these approaches individually and then only compare them.
Maturity Matching Approach
This strategy of financing the working capital is with moderate risk and moderate profitability.
In the maturity matching approach, each of the assets would be financed by a debt instrument of roughly the same maturity. This means that if the asset is maturing after let’s say, 40 days, the due date for the payment of debt which it financed would also be around 40 days.
Short term funds are used to finance fluctuating current assets while long term debts and equity funds are used to finance the permanent level of current assets and fixed assets. This approach is somewhere in between the aggressive approach and conservative …show more content…
liquidity. Here, funds remain on the balance sheet until they are in use. They are paid for as soon as they are not required. This is how interest costs are optimized in this strategy. Interest is only paid for the amount and time for which money is used. All cash are utilized and nothing is left lying unused with the business.
The second advantage of using the maturity matching approach is the saving one receives on interests’ costs. When short term requirements are not financed with long term requirements, a company saves on the interest rate differentiation between the short term interest rates and the long term interest rates. Long term interest rates are moderately higher as a result of the risk premium.
The final advantage is that there are no risks of refinancing and interest rate instability during refinancing. One of the basic principles of finance is pursued here. This means that long term assets are to be with long term finance and short term assets are to be with short term finance. Hence, risks of refinancing and the interest rate fluctuations during refinancing are non-existent. An example would be while renewing a loan, if the markets state of affairs modifies, the rate of interest too will possibly also change unfavourably. Therefore, frequent refinancing is not a
Working capital management looks at the relationship between a firm's short-term assets and its short-term liabilities. The main goal of working capital management is to ensure that a firm has adequate cash flow for their operations and has the most productive use of their resources. Net working capital is the excess of current assets over current liabilities. Since current assets can be financed by either current liabilities or long term funds, the excess of current assets must be financed by long term funds.
There are 2 main sources of funds for working capital management and they are current liabilities and long term funds. Current liabilities are a cheaper source of funds than long term funds. The level of working …show more content…
All these three strategies are different because of their various trade-offs between risk and profitability and their proportion of application of long term fund and short term fund to finance the working capital.
First, we’ll look at these approaches individually and then only compare them.
Maturity Matching Approach
This strategy of financing the working capital is with moderate risk and moderate profitability.
In the maturity matching approach, each of the assets would be financed by a debt instrument of roughly the same maturity. This means that if the asset is maturing after let’s say, 40 days, the due date for the payment of debt which it financed would also be around 40 days.
Short term funds are used to finance fluctuating current assets while long term debts and equity funds are used to finance the permanent level of current assets and fixed assets. This approach is somewhere in between the aggressive approach and conservative …show more content…
liquidity. Here, funds remain on the balance sheet until they are in use. They are paid for as soon as they are not required. This is how interest costs are optimized in this strategy. Interest is only paid for the amount and time for which money is used. All cash are utilized and nothing is left lying unused with the business.
The second advantage of using the maturity matching approach is the saving one receives on interests’ costs. When short term requirements are not financed with long term requirements, a company saves on the interest rate differentiation between the short term interest rates and the long term interest rates. Long term interest rates are moderately higher as a result of the risk premium.
The final advantage is that there are no risks of refinancing and interest rate instability during refinancing. One of the basic principles of finance is pursued here. This means that long term assets are to be with long term finance and short term assets are to be with short term finance. Hence, risks of refinancing and the interest rate fluctuations during refinancing are non-existent. An example would be while renewing a loan, if the markets state of affairs modifies, the rate of interest too will possibly also change unfavourably. Therefore, frequent refinancing is not a