Chapter 26 THEORY OF WORKING CAPITAL MANAGEMENT INTRODUCTION This chapter analyses the theory of working capital management and is divided into four section. The first section explains the nature of working capital in terms of the basic concepts, strategies and polici policies es of workin working g capita capitall manag manageme ement. nt. The trade-o trade-off ff betwee between n profitability and risk is elaborated in section 2. The determination of fina financ ncin ing g mix mix is expl explai aine ned d in Sect Sectio ion n 3. The The majo majorr poin points ts are are .recapitulated in the last Section Section I NATURE OF WORKING CAPITAL Working capital management is concerned with the problems that aris arise e in atte attemp mpti ting ng to mana manage ge the the curr curren entt asse assets ts,, the the curr curren entt liabilities and the interrelationship that exists between them. The term current assets refer to those assets which in the ordinary course of business can be, or will be, converted into cash within one year year withou withoutt underg undergoin oing g a diminu diminutio tion n in value value and withou withoutt disrupting the operations of the firm. The major current assets are cash, marketabl marketable e securities, securities, accounts receivabl receivable e and inventory. inventory. Current liabilities are those liabilities which are intended, at their inception, to be paid in the ordinary course of business, with in a year, out of the current assets or earnings of the concern. The basics current liabilities are accounts payable, bills payable, bank overdraft, and outstanding expenses. The goal of working capital mana manage geme ment nt is to mana manage ge the the firm firm’s ’s curr curren entt asse assets ts and and liabilities in such a way that a satisfactory level of working capita capitall is mainta maintaine ined. d. This This is so beca becaus use e if the the firm firm cann cannot ot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of the
firm while not keeping too high a level of any one of them. Each of the short-term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way. The intera interacti ction on betwee between n curren currentt assets assets and curren currentt liabil liabiliti ities, es, is .therefore, the main theme of the theory of working management The basic ingredients of the theory of working capital management may be said to include its definition, need, optimum level of current asse assets ts,, the the trad tradee-of offf betw betwee een n prof profit itab abil ilit ity y and and risk risk whic which h is associated with he level of current assets and liabilities. Financing.mix strategies and so on Concepts and Definitions of Working Capital .There are two concepts of working capital : gross and net The The term term gross gross workin working g capita capitall, also also refe referr rred ed to as work workin ing g .capital, means the total current assets The term net working capital can be defined in two ways: (i) the most most comm common on defi defini niti tion on of net net work workin ing g capi capita tall (NWC (NWC)) is the the differ differenc ence e betwee between n curren currentt assets assets and curren currentt liabil liabiliti ities; es; and ii) alternate definition of NWC is that portion of current assets which is financed with long-term funds.1 The The task task of the the fina financ ncia iall mang manger er in mana managi ging ng work workin ing g capi capita tall effici efficient ently ly is to ensure ensure suffic sufficien ientt liquid liquidity ity in the operat operation ion of the enterprise. The liquidity of business firm is measure by its ability to satisfy short-term obligations as they become due. The three basic measures of firm’s overall liquidity are (i) the current ratio, (ii) the acid-test ratio, and (iii) the net working capital. The suitability of the first two measures has already been discussed in detail in chapter 4. In brief, they are very useful in interfirm comparisons of liquidity. Net working working capita capitall (NWC) (NWC) as a measur measure e of liquid liquidity ity,, is not very useful for comparing the performance of different firms, but it is quite of liquidity, is not very useful for comparing the performance of different firms, but it is quite useful for internal control. The NWC
helps in comparing the liquidity of the same firm over time. For purpose of working capital management, therefore NWC can be said to measure the liquidity of the firm. In other words, the goal of working capital management is to mange the current assets and liab liabil ilit itie ies s in such such a way way that that an acce accept ptab able le leve levell of NWC NWC is .maintained The common common Defini Definitio tion n of NWC and its Implic Implicati ations ons NWC is commonly defined as the difference between current assets and current current liabiliti liabilities. es. Efficient Efficient working working capital capital managemen managementt requires requires that firms should operate with some amount of NWC, the exact amount varying fro firm to firm and depending, among other things, on the nature of industry The theoretical justification for the use of NWC to measure liquidity is based on the premise that the greater the the marg margin in by whic which h the the curr curren entt asse assets ts cove coverr the the shor shortt-te term rm obligations, the more is the ability to pay obligations when they become due for payment. The NWC is necessary because the cash outflows and inflows do not coincide. In other words, it is the non synchronous nature of cash flows that makes NWC necessary. In genera general, l, the cash cash outflo outflows ws result resulting ing from from paymen paymentt of curren currentt liabilities are relatively predictable. The cash inflows are, however difficult to predict. The more predictable the cash inflows are, the less NWC will be required. A firm, say an electricity generation compan company, y, with with almost almost certai certain n and predic predictab table le cash cash inflow inflows s can operate with little or no NWC. But where cash inflows are uncertain, it will be necessary to maintain current assets at a level adequate .to cover current liabilities, that is there must be NWC Alternative Definition of NWC NWC can alternatively be defined as that part of the current assets which are financed with long-term funds. Since current represent sources of short-term funds, as long as current assets exceed the current liabilities, the excess must be financed with long-term funds. This alternative definition, as shown
subs subseq eque uent ntly ly,, is more more usef useful ul for for the the anal analys ysis is of the the trad tradee-of off f .between profitability and risk SECT SE CTIO ION N 2, TRAD TRADE_ E_ OFF OFF BETW BETWEE EEN N PROF PROFIT ITAB ABIL ILIT ITY Y AND AND RISK In evaluating evaluating a firms firms NWC position an importan importantt considerati consideration on is the trade-off between profitability and risk. IN other words, the level of NWC has a bearing on profitability as well as risk. The term profitability used used in this this cont contex extt is meas measur ured ed by prof profit its s afte after r expense. The term risk is defined as the probability that a firm will become technically insolvent so that it will not be able to meet its .obligations when they become due for payment The risk of becoming technically insolvent is measured using NWC. It is assumed that the greater the amount of NWC, the less riskprone the firm is. Or, the greater the NWC, the more liquid is the firm firm and, and, ther theref efor ore, e, the the less less like likely ly it is to beco become me tech techni nica call lly y insolvent. Conversely, lower of NWC and liquidity are associated with increasing levels of risk. The relationship between liquidity, NWC and risk is such that if either NWC or liquidity increases, the .firm’s risk decreases Nature of Trade-off If a firm wants to increase its profitability, it must also increase its risk. If it is to decrease risk, it must decrease profitability. The tradeoff off betw betwee een n thes these e vari variab able les s is that that rega regard rdles less s of how how the the firm firm incr increa ease ses s its its prof profit itab abil ilit ity y thro throug ugh h the the mani manipu pula lati tion on of work workin ing g cap capital ital,, the cons conseq eque uenc nce e is a corr corres esp pondi onding ng incr incre ease ase is a .corresponding increase in risk as measured by the level of NWC The effects of changing current assets and current liabilities on profitability-risk trade-off are discussed first and subsequently they have have been been inte integr grat ated ed into into an over overal alll theo theory ry of work workin ing g capi capita tall .management
In evaluating the profitability-risk trade-off related to the level of NWC, three basic assumptions, which are generally true, are : (i) that that we are are deal dealin ing g with with a manu manufa factu cturi ring ng firm firm;; (i) (i) that that we are are dealing with a manufacturing firm: (ii) that current assets are less profitab profitable le than fixed assets; and (iii) that short-term short-term funds are less .expensive than long-term funds Effect of the level of current assets on the profitability-risk trade-off The trade-off The effect of the level of current assets on profitability-risk and trade-off can be shown, using the ratio of current assets to total assets. This ration indicates the percentage of total assets that are in the form of current assets. A change in the ration will reflect a change in the amount of current assets. It may either increase or .decrease Effe Effect ct of High Higher er Rati Ratio o An incr increa ease se in the the rati ratio o increase / of current assets to total assets will leads to a decline in profitability becaus because e curren currentt assets assets are assume assumed d to be less less profit profitabl able e than than fixed assets. A second effect of the increase in the ratio will be that the risk risk of techn technica icall insolv insolvenc ency y insolv insolvenc ency y would would also also decrea decrease se because the increase in current assets, assuming no change in current liabilities, will increase NWC. This is shown in example 26.1 .Balance sheet of Hypothetical ltd Asset Amount (in lacks)
Liabilities Amount
current assets
Rs. 3,200
current liabilities Rs 5,400
Fixed assets
4,800
Long-term debt 8,600
6,000
Equity capital
14,000 14,000
If the company earns approximately 2 per cent on its current assets and 12 per cen cent on its fixed xed asse ssets, it can cur current ently earn approximately Rs. 1,140 {(0.02 x Rs 5,400) + (0.12 x Rs 8,600) on its total assets. The NWC currently is Rs 2,200 (Rs 5,400 - Rs 3,200). The current assets to total assets ratio is 0.386 (Rs. 5,400 .(Rs 14,000 Assuming the company increase the investment in current assets by investing an additional Rs 600 in current assets (and thus 600 less in fixed assets), the ratio of current assets to total assets would be 0.429 (Rs. 6,000 - Rs. 14,000). The profits on total assets would Rs 1,080 {(0.02 x Rs 6,000) + (0.12 x Rs 8,000)}. Thus, as the current-total asset ratio increases from 0.386 to 0.429, the total profits decrease from Rs 1,140 to Rs 1080. The risk measured by the amount amount of NWC decrease decreases, s, since since NWC increase increases s from from Rs .2,200 to Rs 2,800 leading to a improvement in liquidity Effe Effect ct of Decr Decrea ease se / Lowe Lowerr Rati Ratio o A decrease in the ratio of current assets to total assets will result in an increase in profitability as well as risk. The increase in profitability will primarily be due to the the corr corres espo pond ndin ing g incr increa ease se in fixe fixed d asse assets ts which which are are like likely ly to generate higher returns. Since the current assets decrease without a corresponding reduction in current liabilities, the amount of NWS .will decrease, thereby increasing risk To illustrate the effect of a decrease in the level of current assets, let us assume that in the case of the Hypothetical Ltd in Example 15.1 15.1,, the the inve invest stme ment nt in fixe fixed d asse assets ts is incr increa ease sed d by Rs 600 600 (imp (imply lyin ing g ther thereb eby y a decr decrea ease se in curr curren entt asse assets ts by a simi simila lar r amount). As a result, the ratio of current assets to total assets would be 0.343 (Rs. 4,800 - Rs 14000). The profits on total assets will be Rs 1,200 {(0.02 x Rs 4,800) + (0.12 x Rs 9,200)}. The NWC will be Rs 1,600 (Rs 4,800 - 3,200). It is, thus, evident that a decrease in the current total assets ratio leads to an increase in
both profitability and risk. The effect of changes (increase as well .as decrease) in current assets are tabulated in Table 26.1 Effect of change in current liabilities on profitability-risk tradeoff As in the case of current assets, the effect of a change in current liabilities can also be demonstrated by using the ratio for curr curren entt liab liabil ilit itie ies s to tota totall asse assets ts.. This This rati ratio o will will indi indica cate te the the .percentage of total assets financed by current liabilities The effect of a change in the level of current liabilities would be that the current liabilities-total asset ratio will either (i) increase, or (ii) .decrease Effect of an increase in the ratio one effect of an increase in the ratio of current liabilities to total assets would be that profitability will increase. The reason for the increased profitability lies in the fact that current liabilities, which are a short-term source of finance, will increase, whereas the long-term sources of finance will be reduce. As short-term short-term sources of finance finance are less expensive than long-run sources, sources, increase in the ratio will, in effect, effect, mean substitut substituting ing less expensive sources for more expensive sources of financing. There will, therefore, therefore be a decline in cost and a corresponding .rise in profitability The increased ratio will also increase the risk. Any increase in the current liabilities, assuming no change in current assets, would adversely affect the NWC. A decrease in NWC leads to an increase in risk. Thus, as the current liabilities-total assets ratio .increase, profitability increases, but so does risk For the Hypothetical Ltd in Example 15.1 let us assume that the current liabilities cost approximately 3 percent, while the average cost of long-term funds is 8 per cent. The cost would be Rs. 960 {(0.03 x Rs 3,200) + (0.08 x Rs 10800)}. The NWC will be Rs. 2,200. The initial ratio of current liabilities to total assets is 0.229 .((Rs. 3,200 - Rs 14,000
Further assume that the company shifts Rs 600 from long-term funds funds to current liabilities liabilities so that the forme forme will decline, decline, while the latter latter will increase increase by the amount. amount. As an result, result, the ratio ratio of current liab liabil ilit itie ies s to tota totall asse assets ts will will incr increa ease se to 0.27 0.271 1 (Rs (Rs 3,80 3,800 0 - Rs 14,000); the cost will decline to Rs 930 {0.03 x Rs 3,800) + (0.08 x Rs 10800)} and the NWC will be lower at the leave of Rs 1,600 (Rs 5,400 - 3,800). These figures amply demonstrate that the increase in the ratio of current liabilities to total assets causes a decline in cost and, therefore, a rise in profitability. At the same time, risk meas measur ured ed by the the leve levell of NWC NWC incr increa ease ses, s, sinc since e the the NWC, NWC, or .liquidity, decreases Effect of a decrease in the ratio The consequences of a decrease in the ratio are exactly opposite to the results of an increase. That is, it will lead to a decrease in profitability as well as risk. The use of more long-term funds which, by definition, are more expensive will increase the cost; by implication, profits will also decline. Similarly, risk will decrease because of the lower level of of current liabilities on .the assumption that current assets remain unchanged Suppose the Hypothetical Ltd of Example 26.1 reduces its current liabilities by Rs 600 as compared to the initial level of Rs 3,200. The reduction in the current liabilities is naturally associated with an increase in the long-term funds by a similar amount. The resulting ratio will be 0.186, that is, slightly lower than the initial ratio of 0.229 (Rs 3,200 - Rs 14,000). A reduction in the ratio causes a rise in cost which will now be Rs 990 (0.03 x Rs 2,600) + (0.08 x Rs 11,400)}; the NWC will also rise to Rs 2,800 (Rs 5,400 - Rs 2,600). While the increase in cost logically denotes a decline in profitability, the the incr increa ease se in NWC NWC refl reflec ects ts an impr improv ovem emen entt in liqu liquid idit ity y and and .reduction inrisk
The effect of changes in the current liabilities -to a assets ratio may .be summarized in Table 26.2 Effect of changes in current liabilities of Hypothetical Ltd
Combined Effect of Changes in Current Assets and Current Liabilities on Profitability-Risk Trade off The combined effects of changes in current assets and current liabilities can be measured by cons consid ider erin ing g them them simu simult ltan aneo eous usly ly.. We have have show shown n in the the preceding sections the effects of a decrease in the current assetstota totall asse assets ts rati ratio o and and the the effe effect cts s of an incr increa ease se in the the curr curren entt liabil liabiliti ities es - total total assets assets ratio. ratio. These These change changes, s, when when consid considere ered d indepe independe ndentl ntly, y, lead lead to an increa increased sed profit profitabi abilit lity y couple coupled d with with a corr corres espo pond ndin ing g incr increa ease se in risk. risk. The The comb combin ined ed effe effect ct of thes these e changes should, logically, be to increase over all profitability as also risk at the same time decrease NWC. This is depicted in Table .26.3 Combined Effects of Changes in Current Assets and Liabilities .on Hypothetical Ltd on Profits and NWC
It can, thus, be seen from these figures that the net effect of the two changes taken together is that profits have increased by Rs 90 and NWC (liquidity) (liquidity) has decreased decreased by Rs 1,200. The trade-off trade-off is clear; clear; the company has increased its profitability by increasing its risk. The NWC has been reduced from its initial level of Rs 2,200 to Rs 1,000. 1,000. The initia initiall net profit profit of the the compan company y (i.e. (i.e. the the differ differenc ence e betw betwee een n init initia iall prof profit its s on tota totall asse assets ts and and the the init initia iall cost cost of financing) was Rs. 180 (Rs. 1,140 - Rs 960). After the change in the the curr curren entt asse assets ts and and liab liabil ilit itie ies, s, the the prof profit its s on tota totall asse assets ts
increased to Rs 1,200 while the cost of financing decreased to Rs 930; its net profits, therefore, increased to Rs 270 (Rs. 1,200 - Rs .(930 Section 3 Determining Financing Mix Apar Apartt
from from the the
prof profit itab abil ilit ity-r y-ris isk k
trad tradee-of off, f, anot anothe herr
impo import rtan antt
ingr ingre edie dient of the theor heory y of work workin ing g cap capita ital mana anagem gement ent is determini determining ng the financing is. One of the most importan importantt decisions, decisions, in other words, involved in the management of working capital is how current assets will be financed. There are, broadly speaking, two two sour source ces s from from whic which h fund funds s can can be rais raised ed for for curr curren entt asse assett financing; (i) short-term sources (current liabilities), and (ii) longterm term sour source ces, s, such such as shar share e capi capita tal, l, long long-t -ter erm m borr borrow owin ings gs,, intern internall ally y genera generated ted resour resources ces like like retain retained ed earnin earning g and so on. What proportion of current assets should be financed by current liabil liabiliti ities es and how much much by long-t long-term erm resour resources? ces? Decisi Decisions ons on .such questions will determine the financing mix There There are three three basic basic approa approaches ches to determ determine ine an approp appropria riate te financ financing ing mix; mix; (a) Headin Heading g approa approach, ch, also also called called the Matchi Matching ng approach; (b) Conservative approach, and (c) Trade-off between .these two Hedging Approach There term ‘hedging’ is often used in the sense of a risk-reducing investment strategy involving transactions of a simultaneous but opposing nature so that the effect of one is likely to counterbalance the effect of the other. With reference to an appropriate financingmix, mix, the the term term hedg hedgin ing g can can be said said to refe referr to the the proc proces ess s of matching maturities of debt with the maturities of financial needs. This approach to the financing decision to determine an appropriate .financing mix is, therefore, also called as matching approach
according to this approach, the maturity of the sources of funds should match the nature of the assets to be financed. For the purpose of analysis, the current assets can be broadly classified ;into two classes Those which are required in a certain amount for a
.1
.given level of operation and, hence, do not vary over time .Those which fluctuate over time
.2
The hedging approach suggests that long-term funds should be used to finance the fixed portion of current assets requirements as spelt out in (1) above, in a manner similar to the financing of fixed assets. assets. The purely temporary temporary requirements, requirements, that is the seasonal variations over and above the permanent financing needs should be appropriately financed with short-term funds (current liabilities). This approach, therefore, divides the requirements of total funds into permanent and seasonal components, each being financed by a different source. This has been illustrated in Table 26.4 Estimated total funds requirements of Hypothetical Ltd
According to the hedging approach, the permanent portion of funds required (col.3) should be financed with long-term funds and the seasonal portion (col.4) with short-term funds. With this approach, the short-term short-term financing financing requireme requirements nts (current (current assets) assets) would be .( just equal to the short-term financing available (current liabilities Conservation approach This This approa approach ch sugges suggestt that that the estim estimate ated d requir requireme ement nt of total total funds should be met from long-term sources; the use of short-term funds should be restricted to only emergency situation or when
there here is an une unexpec xpecte ted d outfl utflo ow of funds unds.. In the case case of the the Hypothecate Ltd in Table 26. 4 the total requirements, including the entire Rs 9,000 needed in October, will be financed by long-run sources. The short-te -term funds will be used only to meet cond conduc ucta tanc nces. es. The The amou amount nts s give given n in colu column mn 4 of Tabl Table e 26.4 26.4 represent represent the extent extent to which short-term short-term financial financial needs are being financed by long-term funds, that is, the NWC. The NWC reaches the highest level (Rs 2,100) in October (Rs. 9,000 - Rs 6,900). Any long-term financing in excess of Rs 6,900 in permanent financing .the needs of the company represents NWC Comparison of Hedging approach with conservative approach A comparison of the two approaches can be made on the basis of .(i) cost considerations, considerations, and (ii) risk consideration Cost Cost cons consid ider erat atio ions ns The The cost cost of thes these e fina financ ncin ing g plan plans s has has a bearing on the profitability of the enterprise. We assume that the cost of short-term funds and long-term funds, as in the preceding Section dealing with profitability-risk trade-off, is 3 per cent and 8 .per cent respectively Hedging Plan The cost of financing under the digging plan can be estima estimated ted as follow follows s : (i) Cost of short-term funds: The cost of .short-term funds = average annual short-term loan x interest rate Aver Averag age e annu annual al shor shorte term rm loan loan = tota totall of mont monthl hly y seas season onal al .requirements (Col.4) divided by the number of months Average annual short-term short-term loan = Rs 11,600 - 12 = Rs 966.67 966.67 .Short-term cost = Rs 966.67 x 0.03 = Rs 29 ii) Cost Cost of long-ter long-term m funds funds = ( Averag Average e annual annual long - term term fund fund ) requirement ) X ( annual interest rate ) .Rs 6,900 X 0,08 = Rs 552 =
iii) Total cost under hedging plan = total of (i) + (ii)
= Rs 29 + Rs ) 552 = Rs 581
Conservative plan The cost of financing under the conservative plan is equal to the cost of the long - term fund, that is, annual average loan, multiplied by the long -term rate of interest = Rs 9,000 X 0.08 = Rs 720 Thus, the of financing under the conservative approach (Rs 720 ) is higher higher than the cost using using the hedgi hedging ng approach approach (Rs 581). 581). The conser conservat vative ive plan plan for financ financing ing is more more expens expensive ive becaus because e the avai availa labl ble e fund funds s are are not not full fully y util utiliz ized ed duri during ng cert certai ain n
peri period ods; s;
moreover, interest has to be paid for funds which are not actually .( needed (i.e. the period when there is NWC Risk considerations The two approaches approaches can also be contrasted contrasted .on the basis of the risk involved Hedgin Hedging g Approa Approach ch The The hedg hedgin ing g appr approa oach ch is more ore risk risky y in compar comparison ison to the the to the conservat conservative ive approa approach. ch. There There are two reasons for this. First, there is, as already observed, no NWC with the hedging hedging approa approach ch becaus because e no long-t long-term erm funds are used used to finance short-term seasonal needs, that is, current assets are just equal to current liabilities. One the other hand, the conservative approach has a fairly high level of NWC. Secondly, the hedging plan is risky because it involves almost full utilization of the capacity to use short-term funds and in emergency situations it may be .difficult to satisfy the short-term s hort-term needs Conservat Conservative ive approach approach with with the the cons conser erva vati tive ve appr approa oach ch,, in con contras trastt, the the com company pany does oes not not use any any of its its sho short-t rt-te erm borrowings. Therefore, the firm has sufficient short-term borrowing capacity to cover unexpected financial needs and avoid technical .insolvency To summaries, the hedging approach is a high profit (low cost)high risk (no NWC) approach to determine an appropriate financing-mix.
In contrast, contrast, the conservative conservative approach approach is low profit (high cost) low risk risk (hig (high h NWC) NWC).. The The cont contra rast st betw betwee een n thes these e appr approa oach ches es is .indicative of the need for trade-off between profitability and risk A trade-off between the hedging and conservative approaches It has been shown that the hedging approach is associated with high profits as well as high risk, while the conservative approach provides low profits and low risk. Obviously, neither approach by itse itself lf wou would serv serve e the the pur purpose pose of eff efficie icient nt work workin ing g cap capital ital managemental. A trade-off between these two extremes would give an acceptable financing strategy. The third approach -trade-off betwee between n the the two approa approache ches-st s-strik rikes es a balanc balance e and provid provides es a .financing plan that lies between these two extremes The exact trade-off between risk and profitability will differ from case depending on risk perception of the decision makers. One possible possible trade-off trade-off could be assumed to be equal to the average average of the minimum and maximum monthly requirements of funds during a given period of time. This level of requirements of funds may be financed through long-run sources and for any additional financing need need,, shor shortt-te term rm fund funds s may may be used used.. The The brea breakd kdow own n of the the requirement of funds of the Hypothetical H ypothetical Ltd between long-term and shortshort-ter term m source sources s under under the tradetrade-off off plans is shown shown in Table Table .26.5
The figures in Table 26.5 reveal that the maximum fund required is Rs 9,00 9,000 0 (oct (octob ober) er) and and the the mini minimu mum m is Rs 6,90 6,900 0 (May (May). ). The The average (Rs. 9000 + 6,900)/2 = Rs 7,950. In other words, the company should use Rs 7,950 each month (Col. 3) in the form of long-t long-term erm funds funds and raise raise additi additiona onall funds, funds, if needed needed,, thorou thorough gh short-term resources (Current Liabilities). IT is clear from the table
that no short-term funds are required during 5 months, namely, March, March, APril, APril, May, June an December, December, because long-term funds available exceed the total requirements for funds. In the remaining 7 months, the company will have to use short-term funds totalling (Rs. Rs 2,700 (Col 4 i) Cost of short-term funds: = (average annual short-term funds ) required) x (rate of short-tern interest ) = Rs 2,700/12 = Rs 225 x 0.03 = Rs 6.75 ii) Cost of long-term funds = (Average long-term funds required ) x ) (Rate of interest on long-term funds ) = Rs. 7,950 x 0.08 = Rs 636 iii) Total cost of the trade -off plan = Rs R s 6.75 + 636 = Rs. 642.75 ) Risk consideration The NWC under this plan would be Rs. 1,050 ((Rs 7,950 - Rs 6,900 Comp Compar aris ison on of the the Tr Trad adee-of offf plan plan with with the the hedg hedgin ing g and and conservative approaches For For a
comp compar ariso ison n of the three three appro approac ache hes s to deter determi mine ne an
approp appropria riate te financ financing ing -mix, -mix, the summar summary y of the result result of these these approaches on profitability and risk is give in Table. 26.6 Comparison of Trade-off plan Interpretation From the summary of results in Table 26.6. It can be seen clearly that the hedging approach is the most risky while the conservative approach is the least risky. The trade-off plan stands midway; less risky than the hedging approach by more risky than the conservative approach. The measure of risk is the level of NWC. From the point of view of profitability (as reflected in the level of total cost of financing plan) a similar kind of relationship is found to exist, the trade-off plan plan lying between the other other two approaches. The preceding analysis, thus established the trade-off between profitability and risk. In this connection two generalizations are warranted; (i)
the lower the NWC, the higher is the risk present, and (ii) the higher the risk of .insolvency, the higher is the expected profits
