BUSF_A01.qxd

Working capital and liquidity

significant and markets for real assets do not seem to be efficient, liquidation would

usually be expected to have a severely adverse effect on shareholders’ wealth.

Means of remaining liquid

One way to avoid the risk of liquidation is to maintain a large amount of cash on short-

term interest-bearing deposit. In this way, should a need for cash to meet current

liabilities suddenly arise, cash could be made available quickly. Obviously there

would be no point in taking such an approach unless the funds used to establish the

short-term deposit were provided from long-term sources. Otherwise the policy

would have the effect of solving the original problem by creating another group of

short-term claimants who could cause the same difficulty.

The approach of using long-term finance to create a short-term fund would offer the

perfect solution to the liquidity problem but for the nature of the capital market. This

tends to mean, among other things, that businesses usually cannot lend at as high a

rate of interest as they have to pay to borrow. Also, long-term interest rates are usu-

ally higher than short-term ones. So, for the average business, borrowing long-term

and lending short-term, in an attempt to maintain good liquidity and avoid the risk of

liquidation, is likely to be an expensive solution to the problem.

In practice, businesses seem to try to strike a balance between the levels of their cur-

rent assets and current liabilities, that is, a balance between exploiting cheap sources

of short-term finance and the risk inherent in doing so.

It is probably fair to say that, irrespective of the root problem (for example, lack of

profitability), most business failures result immediately from a deficiency in working

capital.

Financing working capital

The amount of funds tied up in working capital would not typically be a constant

figure throughout the year. Only in the most unusual of businesses would there be

a constant need for working capital funding. For most businesses there would

be weekly fluctuations. Many operate in industries that are, to a significant extent,

seasonal in demand pattern. This means that sales revenue, inventories, trade receiv-

ables, and so on, would be at higher levels at some predictable times of the year than

at others.

In principle, the working capital need can be separated into two parts: a fixed part

and a fluctuating part. The fixed part is probably defined in amount as the minimum

working capital requirement for the year.

It is widely advocated that the business should be funded in the way depicted in

Figure 13.3. The more permanent needs (non-current assets and the fixed element

of working capital) should be financed from fairly permanent sources (such as equity

and term loans); the fluctuating element should be financed from a short-term source

(such as a bank overdraft), which can be drawn on and repaid easily and at short

notice.

Figure 13.3 assumes no basic alterations in the levels of any of the assets, except

the fluctuating working capital. In practice, any expansion, contraction or structural

alteration of its operations would also tend to affect the pattern of finance required by

the business.