Which one of the following is an example of a flexible short-term financial policy?

The policy that a firm adopts for short-term finance will be composed of at least two elements:

1. The Size of the Firm's Investment in Current Assets. This is usually measured relative to the firm's level of total operating revenues. A flexible or accommodative short-term financial policy would maintain a high ratio of current assets to sales. A restrictive short-term financial policy would entail a low ratio of current assets to sales.

2. The Financing of Current Assets. This is measured as the proportion of short-term debt to long-term debt. A restrictive short-term financial policy means a high proportion of short-term debt relative to long-term financing, and a flexible policy means less short-term debt and more long-term debt.

The Size of the Firm's Investment in Current Assets

Flexible short-term financial policies include:

1. Keeping large balances of cash and marketable securities.

2. Making large investments in inventory.

3. Granting liberal credit terms, which results in a high level of accounts receivable.

Restrictive short-term financial policies are:

1. Keeping low cash balances and no investment in marketable securities.

2. Making small investments in inventory.

3. Allowing no credit sales and no accounts receivable.

Ross-Westerfield-Jaffe: VII. Financial Planning and 27. Short-Term Finance Corporate Finance, Sixth Short-Term Finance and Planning

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Part VII Financial Planning and Short-Term Finance

Determining the optimal investment level in short-term assets requires an identification of the different costs of alternative short-term financing policies. The objective is to trade off the cost of restrictive policies against those of the flexible ones to arrive at the best compromise.

Current asset holdings are highest with a flexible short-term financial policy and lowest with a restrictive policy. Thus, flexible short-term financial policies are costly in that they require higher cash outflows to finance cash and marketable securities, inventory, and accounts receivable. However, future cash inflows are highest with a flexible policy. Sales are stimulated by the use of a credit policy that provides liberal financing to customers. A large amount of inventory on hand ("on the shelf') provides a quick delivery service to customers and increases in sales.3 In addition, the firm can probably charge higher prices for the quick delivery service and the liberal credit terms of flexible policies. A flexible policy also may result in fewer production stoppages because of inventory shortages.4

Managing current assets can be thought of as involving a trade-off between costs that rise with the level of investment and costs that fall with the level of investment. Costs that rise with the level of investment in current assets are called carrying costs. Costs that fall with increases in the level of investment in current assets are called shortage costs.

Carrying costs are generally of two types. First, because the rate of return on current assets is low compared with that of other assets, there is an opportunity cost. Second, there is the cost of maintaining the economic value of the item. For example, the cost of warehousing inventory belongs here.

Shortage costs are incurred when the investment in current assets is low. If a firm runs out of cash, it will be forced to sell marketable securities. If a firm runs out of cash and cannot readily sell marketable securities, it may need to borrow or default on an obligation. (This general situation is called cash-out.) If a firm has no inventory (a stock-out) or if it cannot extend credit to its customers, it will lose customers.

There are two kinds of shortage costs:

1. Trading or Order Costs. Order costs are the costs of placing an order for more cash (brokerage costs) or more inventory (production set-up costs).

2. Costs Related to Safety Reserves. These are costs of lost sales, lost customer goodwill, and disruption of production schedule.

Figure 27.4 illustrates the basic nature of carrying costs. The total costs of investing in current assets are determined by adding the carrying costs and the shortage costs. The minimum point on the total cost curve (CA*) reflects the optimal balance of current assets. The curve is generally quite flat at the optimum, and it is difficult, if not impossible, to find the precise optimal balance of shortage and carrying costs. Usually we are content with a choice near the optimum.

If carrying costs are low and/or shortage costs are high, the optimal policy calls for substantial current assets. In other words, the optimal policy is a flexible one. This is illustrated in the middle graph of Figure 27.4.

If carrying costs are high and/or shortage costs are low, the optimal policy is a restrictive one. That is, the optimal policy calls for modest current assets. This is illustrated in the bottom graph of the figure.

3This is true of some types of finished goods.

4This is true of inventory of raw material but not of finished goods.

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Edition

Chapter 27 Short-Term Finance and Planning 755

■ Figure 27.4 Carrying Costs and Shortage Costs

Dollars

The optimal amount of current assets. This point minimizes costs.

The optimal amount of current assets. This point minimizes costs.

Flexible policy

Dollars

Total cost

Carrying costs Shortage costs

Amount of current assets (CA)

Total cost

Carrying costs Shortage costs

Amount of current assets (CA)

Restrictive policy

Dollars

Carrying costs

Carrying costs

Amount of current assets (CA)

Carrying costs increase with the level of investment in current assets. They include both opportunity costs and the costs of maintaining the asset's economic value. Shortage costs decrease with increases in the level of investment in current assets. They include trading costs and the costs of running out of the current asset (for example, being short of cash).

Ross-Westerfield-Jaffe: VII. Financial Planning and 27. Short-Term Finance Corporate Finance, Sixth Short-Term Finance and Planning

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© The McGraw-Hill Companies, 2002

Part VII Financial Planning and Short-Term Finance

DETERMINANTS OF CORPORATE LIQUID ASSET HOLDINGS

Firms with High Holdings of Liquid Assets Will Have

Firms with Low Holdings of Liquid Assets Will Have

High-growth opportunities High-risk investments Small firms Low-credit firms

Low-growth opportunities Low-risk investments Large firms High-credit firms

Firms will hold more liquid assets (i.e., cash and marketable securities) to ensure that they can continue investing when cash flow is low relative to positive NPV investment opportunities. Firms that have good access to capital markets will hold less-liquid assets.

Source: Tim Opler, Lee Pinkowitz, René Stultz, and Rohan Williamson, "The Determinants and Implication of Corporate Cash Holdings," Journal of Finance Economics, 62 (1999).

Opler, Pinkowitz, Stulz, and Williamson5 examine the determinants of holdings of cash and marketable securities by publically traded firms. They find evidence that firms behave according to the static trade-off model described earlier. Their study focuses only on liquid assets (i.e., cash and market securities), so that carrying costs are the opportunity costs of holding liquid assets and shortage costs are the risks of not having cash when investment opportunities are good.

Alternative Financing Policies for Current Assets

In the previous section we examined the level of investment in current assets. Now we turn to the level of current liabilities, assuming the investment in current assets is optimal.

An Ideal Model In an ideal economy, short-term assets can always be financed with short-term debt, and long-term assets can be financed with long-term debt and equity. In this economy, net working capital is always zero.

Imagine the simple case of a grain-elevator operator. Grain-elevator operators buy crops after harvest, store them, and sell them during the year. They have high inventories of grain after the harvest and end with low inventories just before the next harvest.

Bank loans with maturities of less than one year are used to finance the purchase of grain. These loans are paid with the proceeds from the sale of grain.

The situation is shown in Figure 27.5. Long-term assets are assumed to grow over time, whereas current assets increase at the end of the harvest and then decline during the year. Short-term assets end at zero just before the next harvest. These assets are financed by short-term debt, and long-term assets are financed with long-term debt and equity. Net working capital—current assets minus current liabilities—is always zero.

5Tim Opler, Lee Pinkowitz, René Stulz, and Rohan Williamson, "The Determinants and Implication of Corporate Cash Holdings," Journal of Financial Economics, 52 (1999).

Ross-Westerfield-Jaffe: VII. Financial Planning and 27. Short-Term Finance © The McGraw-Hill

Corporate Finance, Sixth Short-Term Finance and Planning Companies, 2002

Edition

Chapter 27 Short-Term Finance and Planning

■ FIGURE 27.5 Financing Policy for an Idealized Economy

Dollars

Current assets = Short-term debt.

Current assets = Short-term debt.

Long-term debt plus common stock

Fixed assets

Fixed assets

Long-term debt plus common stock

Time

In an ideal world, net working capital is always zero because short-term assets are financed by short-term debt.

■ FIGURE 27.6 The Total Asset Requirement over Time

Dollars

Total asset requirement

Total asset requirement

Time

Different Strategies in Financing Current Assets Current assets cannot be expected to drop to zero in the real world, because a long-term rising level of sales will result in some permanent investment in current assets. A growing firm can be thought of as having both a permanent requirement for current assets and one for long-term assets. This total asset requirement will exhibit balances over time reflecting (1) a secular growth trend, (2) a seasonal variation around the trend, and (3) unpredictable day-to-day and month-to-month fluctuations. This is depicted in Figure 27.6. (We have not tried to show the unpredictable day-to-day and month-to-month variations in the total asset requirement.)

Now, let us look at how this asset requirement is financed. First, consider the strategy (strategy F in Figure 27.7) where long-term financing covers more than the total asset requirement, even at seasonal peaks. The firm will have excess cash available for investment in marketable securities when the total asset requirement falls from peaks. Because this approach implies chronic short-term cash surpluses and a large investment in net working capital, it is considered a flexible strategy.

When long-term financing does not cover the total asset requirement, the firm must borrow short-term to make up the deficit. This restrictive strategy is labeled strategy R in Figure 27.7.

Ross-Westerfield-Jaffe: VII. Financial Planning and 27. Short-Term Finance © The McGraw-Hill

Corporate Finance, Sixth Short-Term Finance and Planning Companies, 2002

Edition

758 Part VII Financial Planning and Short-Term Finance

■ FIGURE 27.7 Alternative Asset-Financing Policies

Strategy F

Dollars

Strategy F

Strategy R

Dollars

Strategy R

Total asset requirement

Time

Strategy F always implies a short-term cash surplus and a large investment in cash and marketable securities. Strategy R uses long-term financing for secular asset requirements only, and short-term borrowing for seasonal variations.

Total asset requirement

Time

Strategy F always implies a short-term cash surplus and a large investment in cash and marketable securities. Strategy R uses long-term financing for secular asset requirements only, and short-term borrowing for seasonal variations.

Which Is Best?

What is the most appropriate amount of short-term borrowing? There is no definitive answer. Several considerations must be included in a proper analysis:

1. Cash Reserves. The flexible financing strategy implies surplus cash and little short-term borrowing. This strategy reduces the probability that a firm will experience financial distress. Firms may not need to worry as much about meeting recurring, short-run obligations. However, investments in cash and marketable securities are zero net-present-value investments at best.

2. Maturity Hedging. Most firms finance inventories with short-term bank loans and fixed assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent financing and is inherently risky, because short-term interest rates are more volatile than longer rates.

3. Term Structure. Short-term interest rates are normally lower than long-term interest rates. This implies that, on average, it is more costly to rely on long-term borrowing than on short-term borrowing.

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Chapter 27 Short-Term Finance and Planning 759

Questions

£ i--------• What keeps the real world from being an ideal one where net working capital could alo j ? ways be zero?

0 \ • What considerations determine the optimal compromise between flexible and restrictive

^ 1 net working capital policies?

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