Working Capital Problem Essay

3116 Words Dec 25th, 2013 13 Pages
Working-Capital Management

ORIENTATION

I. Managing current assets

A. The firm’s investment in current assets (such as fixed assets) is determined by the marginal benefits derived from investing in them compared with their acquisition cost.

B. However, the current fixed-asset mix of the firm’s investment in assets is an important determinant of the firm’s liquidity. That is, the greater the firm’s investment in current assets, other things remaining the same, the greater the firm’s liquidity. This is generally true, since current assets are usually more easily converted into cash.

C. The firm can invest in marketable securities to increase its liquidity. However, such a policy involves committing
…show more content…
Such a derivation would require estimation of the potential costs of illiquidity which, to date, have eluded precise measurement.

B. However, the "hedging principle" provides the basis for the firm’s working-capital decisions.

1. The hedging principle or rule of self-liquidating debt involves the following: Those asset needs of the firm not financed by spontaneous sources (i.e., payables and accruals) should be financed in accordance with the following rule: Permanent asset investments are financed with permanent sources and temporary investments are financed with temporary sources, of financing.

2. A permanent investment in an asset is one which the firm expects to hold for a period longer than one year. Such an investment may involve current or fixed assets.

3. Temporary asset investments comprise the firm’s investment in current assets that will be liquidated and not replaced during the year.

4. Spontaneous sources of financing include all those sources that are available upon demand (e.g., trade credit—accounts payable) or that arise naturally as a part of doing business (e.g., wages payable, interest payable, taxes payable, etc.).

5. Temporary sources of financing include all forms of current or short-term financing not categorized as spontaneous. Examples include bank loans, commercial paper, and finance company loans.

6. Permanent sources of financing

Related Documents