CHAPTER 13 Financing the business 531Chapter 13 preview
A major concern for all business entities is the way the entity is financed. It is important for managers
to select appropriate funding as all entities need funding, no matter how small or large their turnover or
asset base. The chapter begins with a discussion of working capital and introduces the underlying prin-
ciple that guides the sourcing of funds for various entity uses. This principle forms the foundation for
all later discussion. The chapter then moves on to examine the roles and management of cash, accounts
receivable and inventories, building upon knowledge that was presented in the chapter on the balance
sheet (chapter 5). The sources of short-term finance are discussed, followed by the sources of long-term
finance from both financial institutions and the financial markets. Next, hybrid financial instruments are
discussed. And finally, the chapter examines equity instruments and international finance.
13.1 Managing net working capital
LEARNING OBJECTIVE 13.1 Discuss the management of net working capital.
Working capital is defined as the funds invested in current assets. You should recall that current assets
are the assets the entity expects to be able to convert to cash in the normal course of business within the
next 12 months. Thus, current assets include cash, accounts receivable (debtors) and inventory (stock).
Another relevant concept is net working capital. Net working capital is current assets minus current
liabilities. Current liabilities are debts that will be paid within the next 12 months (or accruals that will
be shortly reversed). Current liabilities normally include trade creditors or accounts payable, accrued
expenses, taxation liabilities, short-term debt such as commercial bills, and provisions for current lia-
bilities such as dividends declared but not yet paid.
In managing the level of net working capital, the entity is concerned with three aspects:
- maintaining liquidity
- the need to earn the required rate of return on assets
- the cost and risk of short-term funding.
Liquidity is a measure of the ease of conversion of an asset into cash. Thus, cash is 100 per cent
or totally liquid. Bank current account balances normally have high liquidity, in that the depositor can
write a cheque and have that document (which is really an instruction to the bank) accepted as cash. On
the other hand, a term deposit at a bank has lower liquidity, as the depositor must either wait until the
term expires or ‘break’ the term by asking for the funds back and incurring a high financial penalty for
doing so.
Entities need liquidity to pay their bills on time. As you can readily appreciate, entities really run on
trust and short-term credit, and entities want to be paid by their accounts receivable or they themselves
may be in danger of failure. Therefore, being able to maintain that trust within the immediate business
environment by paying bills on time is vitally important.
In order to maximise their wealth, investors have a rate of return that they require from investments.
This rate of return was discussed in chapter 12. This requirement applies not only to long-term capital
investments, but also to working capital. Thus, working capital must ‘do its bit’. If working capital is
allowed to increase to an inappropriately high level, it can reduce the average rate of return on equity.
Another aspect that entities must manage is the cost and risk of current liabilities. An entity can
increase its holdings of cash, accounts receivable and inventory at any time, so long as it is able to con-
tract for adequate funds to finance the expansion. The finance has a cost, normally comprising both fees
and interest, and the financial manager must be convinced that the benefits to the entity exceed the cost.
Deciding the appropriate level of net working capital
How does a manager decide the appropriate level of net working capital; that is, a level where the entity
maintains the ability to meet its financial obligations on time? To achieve this, many entities use the
hedging principle. The hedging principle is based on the idea of matching the maturity of the source