Cash and payables management - Working capital funding polic...

Learning Outcomes

After reading this article, you will be able to distinguish between types of current assets and funding needs, explain the main approaches to working capital funding policies, and assess the benefits and risks of aggressive, conservative, and matching strategies. You will also understand the impact of funding choices on liquidity, profitability, and risk, enabling you to answer ACCA FM questions on cash and payables management confidently.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand working capital funding policies and their practical implications. In particular, focus your revision on:

• The distinction between permanent and fluctuating current assets
• The evaluation of aggressive, conservative, and matching working capital funding policies
• The relative costs and risks of short-term and long-term finance
• Factors influencing the choice of funding strategy, including management attitude to risk
• The impact of working capital policy on liquidity and profitability

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is meant by "permanent current assets"?
   1. Assets that never change in value
   2. The minimum level of current assets always required
   3. All cash balances
   4. Only inventory
2. Which funding approach exposes a company to the highest liquidity risk?
   1. Conservative
   2. Matching
   3. Aggressive
   4. Balanced

3. True or false? A conservative funding policy always uses short-term finance for fluctuating current assets and long-term finance for permanent current assets.

4. Briefly explain one advantage and one disadvantage of using short-term borrowing to finance working capital.

Introduction

Efficient management of cash and payables is critical to maintaining liquidity and profitability. This involves not only monitoring collections and payments but also making strategic decisions on how current assets are funded. Choosing the right funding policy affects both the risk and cost associated with short-term operations.

This article examines working capital funding policies, focusing on the types of current assets that must be funded, sources of finance, and the three primary funding strategies: aggressive, conservative, and matching. Understanding these approaches is essential for effective management of cash and payables, and will help you answer FM questions involving working capital structure and risk.

Key Term: working capital
The excess of current assets over current liabilities, representing the funds available to support day-to-day business operations.

Types of Current Assets and Funding Needs

Businesses typically require a baseline amount of current assets—such as inventory, receivables, and minimum cash—to operate throughout the year. In addition, the actual level of current assets fluctuates due to seasonal demand, production cycles, or unexpected events.

Permanent vs Fluctuating Current Assets

• Permanent current assets (also known as core working capital) are the minimum level of current assets a company must hold at all times.
• Fluctuating current assets (also called variable working capital) are the extra assets required to meet peak or seasonal demands.

Key Term: permanent current assets
The baseline level of current assets (such as inventory or receivables) that remains invested in the business all year round.

Key Term: fluctuating current assets
The portion of current assets that vary due to changes in sales volume, production cycles, or seasonality.

Working Capital Funding Policies

Once current assets are identified, management must decide how to finance them. The core decision is whether to use short-term or long-term finance for both permanent and fluctuating current assets.

There are three main policy options:

1. Aggressive Policy

• Permanent and part of fluctuating current assets are funded using short-term finance.
• Long-term finance is reserved for non-current assets and possibly a portion of permanent current assets.
• This approach is lower cost but carries higher liquidity and refinancing risk, as short-term borrowing must be renewed frequently.

2. Conservative Policy

• All permanent, and possibly some fluctuating current assets, are funded using long-term finance.
• Short-term finance is only used for temporary peaks in current asset needs.
• This is safer and reduces liquidity risk, but typically costs more due to higher long-term interest rates.

3. Matching (Hedging) Policy

• Permanent current assets are funded with long-term finance.
• Fluctuating current assets are funded with short-term finance.
• This seeks to match the maturity of funding with asset lifetimes to balance risk and cost.

Key Term: aggressive working capital policy
A funding strategy that uses more short-term finance to fund both permanent and fluctuating current assets, aiming for lower cost but exposing the business to higher liquidity risk.

Key Term: conservative working capital policy
A funding strategy that uses long-term finance for both permanent current assets and some fluctuating assets, reducing risk but incurring greater funding costs.

Key Term: matching (hedging) working capital policy
A policy under which the maturities of assets and their corresponding funding are aligned, i.e., stable assets funded by long-term finance and variable assets by short-term finance.

Worked Example 1.1

A company forecasts it will always need $200,000 invested in inventory and receivables, but during its busiest season, working capital increases to $300,000. It can borrow short-term at 6% or long-term at 9%.
What are the risks and benefits if the company funds all $300,000 with short-term borrowing (aggressive policy)?

Answer:
The firm enjoys lower overall interest expense, as short-term rates (6%) are cheaper than long-term rates (9%). However, funding all working capital with short-term borrowing increases liquidity risk. If lenders are unwilling to renew loans, the firm may struggle to meet obligations, possibly disrupting operations.

Relative Risk and Cost

Factors Influencing Policy Choice

• Management's attitude to risk and previous funding decisions
• Industry volatility and seasonality
• Size of the business (larger firms may access long-term debt more easily)
• Flexibility needed for growth or unexpected outflows

Worked Example 1.2

Smith Co always needs $50,000 in working capital, but for three months each year, needs an extra $30,000. Management is risk-averse. Should it use short-term or long-term finance for the additional $30,000?

Answer:
A risk-averse management should use a conservative or matching policy—funding the stable $50,000 with long-term finance and the temporary $30,000 with short-term finance. Using short-term finance only for the temporary increase helps avoid unnecessary cost while limiting liquidity risk.

Short-term vs Long-term Finance: Summary

• Short-term finance is usually cheaper but less stable, with renewal risk and exposure to rising interest rates.
• Long-term finance is more expensive but secures funds for a longer period and provides stability.

Exam Warning

Remember: Funding all working capital with short-term finance may minimize cost on paper but increases the risk that the business cannot refinance if credit markets tighten. For exams, always discuss both cost and liquidity risk.

Summary

Choosing an appropriate working capital funding policy involves analyzing asset needs, weighing funding cost against risk, and aligning the maturity of finance to the use of funds. The right policy will depend on business risk tolerance and operational requirements.

Key Point Checklist

This article has covered the following key knowledge points:

• Define permanent and fluctuating current assets and explain their funding needs
• Describe aggressive, conservative, and matching working capital funding policies
• Compare the cost and risk of short-term and long-term finance for working capital
• Evaluate factors influencing the choice of funding policy
• Understand how working capital funding policy impacts liquidity, risk, and profitability

Key Terms and Concepts

• working capital
• permanent current assets
• fluctuating current assets
• aggressive working capital policy
• conservative working capital policy
• matching (hedging) working capital policy