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(^168) Financial Management
The figure represents, of course, an idealized situation- current assets build up gradually
as crops are purchased and processed, inventories are drawn down less regularly, and
ending inventory balances do not decline to zero. Nevertheless , the example does
illustrate the general nature of the production and financing process, and working
capital management consists of decisions relating to the top section of the graph-
managing current assets and arranging the short-term credit used to finance them.
Figure 1: Fixed and Current Assets and Their Financing
Extending The Working Capital Concept
As the economy became less oriented toward agriculture, the production and financing
cycles of ì typicalíí business changed. Althought seasonal patterns still existed, and
business cycles also caused asset requirements to fluctuate, it became apparent that
current assets rarely, if ever , dropped to zero. This realization led to the development
of the idea ofí permanent current assets,íí diagrammed in Figure ñ2. As the figure is
drawn, it maintains the traditional notion that permanent assets should be financed with
long ñterm capital, while temporary assets should be financed with short-term credit.
The pattern shown in Figures -1 and -2 was considered to be desirable because it
minimizes the risk that the firm maybe unable to pay off its maturing obligations To
illustrate, suppose a firm borrows on a one-year basis and uses the funds obtained to
build and equip a plant. Cash flows from the plant (profit plus deprecation) are not
sufficient to pay of lone at the end of the year. So the loan, then the firm has problems
had the plant been financed with long term debt, however, cash flows would have been
sufficient to retire the loan, and the problem of renewal would not have arisen .Thus,
if a firm finances long-term assets with permanent capital and short-term assets with
temporary capital, its financial risk is lower than it would be if long-term assets were
financed with short-term debt.
0 1 2 3 4
Dollars
Current assets
Short-term
credit
Long-term
debt plus
equity capital