532 Accounting: Business Reporting for Decision Making
of funding with its use. The financial manager has control over the maturity of loan contracts, which are
entered into for funding, and so can match loan maturities to expected cash inflows. Thus, a retail store
preparing for the Christmas trading period may have to pay supply invoices by 7 December. To pay the
bills, the manager could arrange for 30-day funding, repayable on 6 January, on the basis that the store
will have recouped all of the outlays, plus earned a profit margin, by that date. The funding will cost,
say, 5 per cent per annum, or 0.41 per cent for the 30 days. The interest charge is an additional cost of
doing business, but it ensures the entity is able to pay its bills on time and maintain a good reputation.
In order to make the hedging principle more useful, it is useful to think in terms of permanent, tem-
porary and spontaneous sources of funding. Permanent funding comprises funding with maturities
greater than one year, and includes long-term debt, leases and ordinary shares. Temporary funding
essentially comprises the short-term formal sources of finance, such as commercial bills and bank loans.
The spontaneous sources of funding are those that arise in a substantially unplanned and unstructured
way in the ordinary course of business. Examples are trade creditors and the various forms of accrued
expenses. Accrued expenses include wages, interest and taxes. Accrued wages are a significant source of
spontaneous finance because employees are effectively lending funds free of charge to their employers
every pay cycle until payday. Similarly, the withholding of pay-as-you-go (PAYG) tax instalments from
employees’ pay, as Australian taxation law requires, until the subsequent payment of the total of these
instalments to the Australian Taxation Office monthly or quarterly, gives entities a significant source of
free funding.
The principles for using the permanent, temporary and spontaneous classifications to advantage are:
- permanent assets should be financed with permanent and spontaneous sources of funding
- temporary assets should be financed with temporary sources of funding.
Why would it be a good idea to finance permanent assets with spontaneous sources of funding? The
answer stems from the fact that there remains a core level of funding that is virtually fixed, even though
the balances of the various types of spontaneous funding are continually changing. Thus, if the totals of
spontaneous funding from all sources over several periods were $140 000, $180 000, $160 000, $140 000
and $180 000, the core level of $140 000, which comprises the minimum level that is always available,
may be treated virtually as permanent funding.
However, the hedging principle does not give any guidance as to the level of net working capital
that provides the optimal return. Such an assessment involves several cost–benefit analyses. The cost
of holding additional cash is the opportunity cost of forgoing higher returns available elsewhere, and
the benefit is the reduced expectation of illiquidity. For example, consider a business with a large sum
of cash sitting in its company bank account. While it may be prudent to have that sum of money avail-
able for any unexpected expenditures, it could also be invested elsewhere; for example, expanding the
business into a new geographic area, purchasing new machinery to double output or investing in a joint
venture. The cost of carrying higher accounts receivable and inventory is, again, an opportunity cost if
internally financed, or a true cash cost of the additional external funding necessary, while the benefits
stem from increasing sales, both currently and in the future. Hence, finding the appropriate level of
accounts receivable and inventory, especially, is more a matter of trial and error. In the final analysis,
entities must maintain an adequate level of working capital, depending on individual circumstances, to
ensure that business is not disrupted and that continuity is maintained in a smooth and efficient manner.
The absolute value of working capital is an important measure (e.g. at the end of the June 2015
reporting period, JB Hi-Fi Ltd held $617 million and the Qantas Group held $5.04 billion), but that
measure alone does not show if the amount of working capital held is appropriate for the business. We
obviously need to know what demands might be placed on these assets — in other words, how do cur-
rent liabilities compare and what are the arrangements in place to repay that debt?
Net working capital gives us a clear or remaining value after current financial obligations (liabilities)
are deducted. As at June 2015 for the companies given in the example above, JB Hi-Fi Ltd’s manage-
ment regarded $237 million as appropriate net working capital and the Qantas Group showed a net
working capital of −$2.4 billion (being a proportion of current assets to current liabilities of 161 per cent