476 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management
businesses increase when the economy is strong; hence, they build up current as-
sets at those times but let inventories and receivables fall when the economy weak-
ens. Note, though, that current assets rarely drop to zero—companies maintain
some permanent current assets, which are the current assets needed at the low
point of the business cycle. Then as sales increase during an upswing, current as-
sets are increased, and these extra current assets are de! ned as temporary current
assets as opposed to permanent current assets. The way these two types of current
assets are! nanced is called the! rm’s current assets! nancing policy.15-3a Maturity Matching, or “Self-Liquidating,”
Approach
The maturity matching, or “self-liquidating,” approach calls for matching asset
and liability maturities as shown in Panel a of Figure 15-2. All of the! xed assets
plus the permanent current assets are! nanced with long-term capital, but tempo-
rary current assets are! nanced with short-term debt. Inventory expected to be
sold in 30 days would be! nanced with a 30-day bank loan, a machine expected to
last for 5 years would be! nanced with a 5-year loan, a 20-year building would be
! nanced with a 20-year mortgage bond, and so forth. Actually, two factors prevent
an exact maturity matching: (1) There is uncertainty about the lives of assets. For
example, a! rm might! nance inventories with a 30-day bank loan, expecting to
sell the inventories and use the cash to retire the loan. But if sales are slow, the cash
would not be forthcoming and the! rm might not be able to pay off the loan when
it matures. (2) Some common equity must be used, and common equity has no
maturity. Still, when a! rm attempts to match asset and liability maturities, this is
de! ned as a moderate current asset! nancing policy.15-3b Aggressive Approach
Panel b of Figure 15-2 illustrates the situation for a more aggressive! rm that
! nances some of its permanent assets with short-term debt. Note that we used the
term relatively in the title of Panel b because there can be different degrees of aggres-
siveness. For example, the dashed line in Panel b could have been drawn below the
line designating! xed assets, indicating that all of the current assets—both perma-
nent and temporary—and part of the! xed assets were! nanced with short-term
credit. This policy would be a highly aggressive, extremely nonconservative posi-
tion; and the! rm would be subject to dangers from loan renewal as well as prob-
lems with rising interest rates. However, short-term interest rates are generally
lower than long-term rates, and some! rms are willing to sacri! ce some safety for
the chance of higher pro! ts.
The reason for adopting the aggressive policy is to take advantage of the fact
that the yield curve is generally upward-sloping; hence, short-term rates are gen-
erally lower than long-term rates. However, a strategy of! nancing long-term as-
sets with short-term debt is really quite risky. To illustrate, suppose a company
borrows $1 million on a 1-year basis and uses the funds to buy machinery that will
lower labor costs by $200,000 per year for 10 years.^2 Cash " ows from the equip-
ment would not be suf! cient to pay off the loan at the end of only 1 year, so the
loan would have to be renewed. If the company encountered temporary! nancial
problems, the lender might refuse to renew the loan, which could lead to bank-
ruptcy. Had the! rm matched maturities and! nanced the plant with a 10-yearPermanent Current
Assets
Current assets that a firm
must carry even at the
trough of its cycles.Permanent Current
Assets
Current assets that a firm
must carry even at the
trough of its cycles.
Temporary Current
Assets
Current assets that
fluctuate with seasonal or
cyclical variations in sales.Temporary Current
Assets
Current assets that
fluctuate with seasonal or
cyclical variations in sales.
Current Asset Financing
Policy
The way current assets are
financed.Current Asset Financing
Policy
The way current assets are
financed.
Maturity Matching, or
“Self-Liquidating,”
Approach
A financing policy that
matches asset and
liability maturities. This is
a moderate policy.Maturity Matching, or
“Self-Liquidating,”
Approach
A financing policy that
matches asset and
liability maturities. This is
a moderate policy.(^2) We are oversimplifying here. Few lenders would explicitly lend money for 1 year to! nance a 10-year asset. What
would actually happen is that the! rm would borrow on a 1-year basis for “general corporate purposes” and then
use the money to purchase the 10-year machinery.