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3.3. Exercise 3.2: Working Capital Finance and Risk

The conventional concept of working capital is defined as an excess of current assets over current liabilities. It represents the net investment from longer-term fund sources (debt, equity or reserves) required to finance the day to day operations of a company.

This definition is based on the traditional accounting notions of financial prudence and conservatism. Because current liabilities must be repaid in the near future, they should not be applied to long term investment. So, they are assumed to finance current assets.

Yet we all know that in reality, new issues of equity or loan stock and retentions are often used by management to finance working capital. Likewise, current liabilities, notably permanent overdraft facilities and additional bank borrowing may support fixed asset formation.

The efficient financing of working capital therefore depends upon how the funding of fixed and current asset investment is divided between an optimum mix of long and short term sources, bearing in mind that under conditions of uncertainty, short-term capital costs are typically lower than long-term capital costs.

And this is where the company's attitude to risk comes into play.

Without getting enmeshed in the intricacies of how the accounting transactions are recorded, or the defects of conventional Balance Sheet analysis, (which are explained in Chapter Three of my bookboon Theory and Business companion texts):

Consider three companies with the following identical asset structures ($million):

Fixed Assets 280; Permanent Current Assets 110; Variable Current Assets 90


Permanent current assets represent their "core" investment in inventory, debtors and cash.

Variable current assets represent their average level of investment to satisfy fluctuations in anticipated demand.

The division between their total current assets and fixed assets is not unrealistic. In the real world, the ratio is often in the region of 1:1.The only difference between the three companies relates to their attitude to financial risk, characterized by preference, aversion and neutrality. In other words, they adopt aggressive, conservative and moderate financing policies respectively, to fund their total asset investment.


Using numerical examples of your choice within a Balance Sheet framework, where total fund sources (long and short) equal their total use, defined by the asset structure above:

1. Compare and contrast how the division between long-term finance and short term finance differs between the three companies, given their differential attitude towards risk.

2. Confirm your commentary with a summary of their working capital (current asset) ratios.

An Indicative Outline Solution

The financing of working capital relates to how fixed asset formation and current asset investment is divided between long-term and short-term sources of funding. Depending on corporate attitudes to financial risk (preference, aversion and neutrality) three broad policies exist; aggressive, conservative and moderate.

Table 3.1 presents a hypothetical data series in a convenient Balance Sheet format for our three companies, which reflects their financial risk profiles as a basis for analysis.

$ million

Company 1 (Aggressive)

Company 2 (Conservative)

Company 3 (Moderate)



































Table 3.1: Comparative Financing Policies

1. The division between long and short term finance

With an aggressive financing policy, Company 1 not only funds its core working capital investment and all fluctuations in variable current assets, but also a proportion of its fixed assets formation, ($20m) with short-term finance.

This policy is designed to provide the highest expected return (because the costs of short-term funds are typically lower than long-term costs in efficient capital markets). But it is also very risky, arising from its illiquidity and the threat of insolvency. Short-term financing may have to be repaid before periodic revenues are realized.

With a conservative policy, Company 2 reverses the logic of Company 1. Risk averse management now prefers long-term financing (equity and debt) that exceeds its fixed asset and permanent current asset base. Short-term financing is only used to fund part of the fluctuation in current assets ($60m).

This policy is supposedly less risky. But it also results in lower returns, because of the higher yields required by the higher proportion of long-term equity and debt-holders in its capital structure.

With a moderate policy, Company 3 falls between the two extremes. It equates short-term finance to the fluctuation in current assets ($90m). Long-term sources, therefore, finance fixed asset investment, plus the permanent component of current assets.

2. The working capital (current asset) ratios.

A comparison of the current asset to current liability ratios for the three companies ($ million) reveals their disparate working capital positions.

I Company 1 (200/240) = 0.83:1 Company 2 (200/60) = 3.3:1 Company 3 (200/90) = 2.2:1 I

Company 1 appears theoretically insolvent compared to the traditional current asset "benchmark" of 2:1 (with which you are familiar). Even without knowledge of the composition of its current assets (inventory, debtors and cash) it is also illiquid, compared to the conventional "quick" asset ratio of 1:1.

At the other extreme, Company 2 is awash with current assets relative to its short-term finance. Accounting concepts of solvency and liquidity criteria are well satisfied. But this may be at the expense of the higher level of profitability sought by Company 1.

Between these polar extremes, Company 3 satisfies working capital conventions, with a risk-return trade-off to ensure adequate performance.

3.4. Summary and Conclusions

Having illustrated different working capital policies, relative to the corporate investment and finance decision within the context of a static Balance Sheet framework, the next question we need to consider is whether it is possible to define an optimum amount of net current assets that a firm ought to hold at any particular time? This is because a high proportion of working capital to total assets may give management greater flexibility to adapt quickly to future economic conditions and increase sales, without compromising debt paying ability.

Two policies spring to mind, mentioned in Chapter Three of the "Theory" and "Business" companion texts to this study. One is strategic and the other is operational, although they need not necessarily be mutually exclusive.

- Reduce short-term assets (rather than borrow) and reinvest the proceeds in fixed assets to meet a forecast increase in long-term output capacity.

- Reduce liquidity temporarily and invest in inventory to satisfy a short-term increase in demand.

However, as we shall discover from the next Chapter's case study, these decisions require a dynamic analysis of the firm's "operating" and "financing" cycles, based on its debtor (accounts receivable) policy and the "terms of sale" dictated by its creditors (accounts payable). Otherwise, management's actions may be tantamount to economic suicide.

3.5. Selected References

Text Books:

Working Capital and Strategic Debtor Management, 2013.

Business Texts:

Working Capital Management: Theory and Strategy, 2013.

Strategic Debtor Management and the Terms of Sale, 2013.

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