Combining liability structure and current asset decisions

In the preceding sections, we examined two broad aspects of working capital management: what level of current assets to maintain and how to finance current assets. These two facets are interdependent. All other things equal, a firm that follows a conservative policy of maintaining high levels of current assets should be in a better position to successfully utilize short-term borrowing than a firm that maintains aggressively low levels of current assets. On the other hand, a firm that finances its current assets entirely with equity will be in a better risk position to take a more aggressive stance when it comes to maintaining low ("lean and mean") levels of current assets. Because of their interdependence, these two aspects of working capital management must be considered jointly.

Uncertainty and the Margin of Safety

If the firm knows with certainty its future sales demand, resulting receivable collections and production schedule it will be able to arrange its debt maturity schedule to correspond exactly to the schedule of future not cash flows.

Assume initially that the firm cannot borrow on short notice to meet unexpected cash drains. As a result, it can provide a margin of safety only by (1) increasing the level of current assets (especially cash and marketable securities), or (2) lengthening the maturity schedule of financing. Both of these actions affect profitability. In the first choice, funds are committed to relatively low-yielding assets. In the second firm may pay interest on borrowings over periods of time when the funds a needed. In addition, long-term debt has a higher expected interest cost than short-term debt.

Risk and Profitability

A decision on the appropriate margin of safety will be governed by consideration risk and profitability and by management's attitude toward bearing risk. Each solution (increasing liquidity, lengthening the maturity schedule, or a combination of the two), will cost the firm something in profit-making ability. For a given risk tolerance management may determine which solution is least costly and then implement that solution. On the other hand, management might determine the least costly solution for various levels of risk. Then management could formulate risk tolerances on basis of the cost involved in providing a margin of safety. Presumably, these tolerances would be in keeping with an objective of maximizing shareholder wealth. If the firm can borrow in times of emergency, the foregoing analysis needs to be modified. The greater the ability of the firm to borrow on short notice, the less it needs to provide for a margin of safety by the means previously discussed. Certain companies can arrange for lines of credit or revolving credits that enable them to borrow on short notice. When a company has access to such credit, it must compare the cost of these arrangements with the cost of other solutions. There are, of course, limits on how much a firm may borrow on short notice.