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Registration number:

Quiz: 3

Class: BBA-6

Course: Financial Management

Submission on: May 18, 2020

Submit to: Sir Hassan Zada

To grasp the concept of working capital management financing policies, we need to understand
there types of assets used by a company. Companies have fixed assets that work for a long time
before they need to be replaced. Fixed asset includes Plant machinery, equipment, land, vehicles
etc. The other type is current assets which last up to one year therefore require investment after
regular interval. The twist here is that current assets has a part of assets that fluctuate and another
part which remains fixed no matter how much the sales drop or the company head towards
recession. Thus we can say that there are two types of current assets.

1. Permanent Current Asset: Permanent current asset is the least amount of inventory
and account receivable that the company has always achieved. As company never falls
short of these assets they remain constant over time.
2. Temporary current Asset: Some portion of current assets keeps changing overtime.
This can be because of changes in business cycle or seasonal sales etc.

The dilemma for any company is what combination of long term fund and short term fund should
be used to finance the Fix asset, Permanent current asset, and Temporary current asset. The
answer to this question is given by Operating Current Asset financing Policies:

Matching Maturity Approach

Using this technique a company chose to finance the entire Fix asset and the Permanent current
asset with long term fund; leaving temporary current asset to be financed with short term fund.
In other words Long term fund is used to acquire all fixed asset + some portion of current asset.

The logic behind this method is simple. Temporary current asset vary over time thus they are
financed by short term debt. As more debt is required for temporary current assets it can easily
be acquired using short term debt. In this way company will never have to hold extra debt which
is not being utilized. The advantage of this approach is that company saves on interest expense,
refinancing fee and interest rate fluctuation.

The only issue with this approach is mismatch. Practically it is impossible to predict when the
sales will be made and when the cash will be received. If the sales get delay the company will
not have money to pay back its creditors.
Relative Aggressive Approach

Adopting this approach a company takes risk to increase its profitability by using short term fund
to acquire not only temporary current assets but also some portion of permanent current asset.
The company is gambling for profit by compromising its liquidity. Its saves interest cost but
when creditors ask for payment the company may struggle to pay them back. The drawback is
higher chance of bankruptcy and the advantage is the increase profit.

The logic here is simple. The firm allows its entire long term fund to be invested in making
profit. The short term fund saves interest cost therefore the company is making most out of it and
covering as much expense with short term fund as possible.

Conservative Approach

Adopting this approach a company reduces its risk by using long-term funds to finance fixed
asset + permanent current asset + partial temporary current asset. The remaining amount of
temporary current asset is finance by short term funds. This a relatively risk free method as
maintain company maintains highly level of current asset which leads to higher working capital
equity.

The logic here is to tradeoff profitability for liquidity. Using long term means company has
higher working capital and in any case company can pay back its creditor immediately using
funds from equity, term loan and debentures.