Businesses require capital—that is, money invested in plant, machinery, inventories, accounts receivable, and all the other assets it takes to run a company efficiently.
Typically, these assets are not purchased all at once but are obtained gradually over time as the firm grows. The total cost of these assets is called the firm’s total capital requirement.
When we discussed long-term planning, we showed how the firm needs to develop a sensible strategy that allows it to finance its long-term goals and weather possible setbacks. But the firm’s total capital requirement does not grow smoothly and the company must be able to meet temporary demands for cash. This is the focus of short-term financial planning.
Figure 2.3 illustrates the growth in the firm’s total capital requirements. The
upward-sloping line shows that as the business grows, it is likely to need additional fixed assets and current assets. You can think of this trendline as showing the base level of capital that is required. In addition to this base capital requirement, there may be seasonal fluctuations in the business that require an additional investment in current assets.
Thus the wavy line in the illustration shows that the total capital requirement peaks late in each year. In practice, there would also be week-to-week and month-to-month fluctuations in the capital requirement, but these are not shown in Figure 2.3.
The total capital requirement can be met through either long- or short-term financing. When long-term financing does not cover the total capital requirement, the firm must raise short-term capital to make up the difference. When long-term financing more than covers the total capital requirement, the firm has surplus cash available for short-term investment. Thus the amount of long-term financing raised, given the total capital requirement, determines whether the firm is a short-term borrower or lender.
The three panels in Figure 2.4 illustrate this. Each depicts a different long-term financing strategy. The “relaxed strategy” in panel a always implies a short-term cash surplus. This surplus will be invested in marketable securities. The “restrictive” policy illustrated in panel c implies a permanent need for short-term borrowing. Finally, panel b illustrates an intermediate strategy: the firm has spare cash which it can lend out during the part of the year when total capital requirements are relatively low, but it is a borrower during the rest of the year when capital requirements are relatively high.
What is the best level of long-term financing relative to the total capital require-
ment? It is hard to say. We can make several practical observations, however.
1. Matching maturities. Most financial managers attempt to “match maturities” of assets and liabilities. That is, they finance long-lived assets like plant and machinery with long-term borrowing and equity. Short-term assets like inventory and accounts receivable are financed with short-term bank loans or by issuing short-term debt like commercial paper.
2. Permanent working-capital requirements. Most firms have a permanent investment in net working capital (current assets less current liabilities). By this we mean that they plan to have at all times a positive amount of working capital. This is financed from long-term sources. This is an extension of the maturity-matching principle. Since the working capital is permanent, it is funded with long-term sources of financing.
3. The comforts of surplus cash. Many financial managers would feel more comfortable under the relaxed strategy illustrated in Figure 2.4a than the restrictive strategy in panel c. Consider, for example, General Motors. At the end of 1998 it was sitting on a cash mountain of over $10 billion, almost certainly far more than it needed to meet any seasonal fluctuations in its capital requirements. Such firms with a surplus of long-term financing never have to worry about borrowing to pay next month’s bills. But is the financial manager paid to be comfortable? Firms usually put surplus cash to work in Treasury bills or other marketable securities. This is at best a zero-NPV investment for a tax-paying firm.
4 Thus we think that firms with a permanent cash surplus ought to go on a diet, retiring long-term securities to reduce long-term financing to a level at or below the firm’s total capital requirement. That is, if the firm is described by panel a, it ought to move down to panel b, or perhaps even lower.
Typically, these assets are not purchased all at once but are obtained gradually over time as the firm grows. The total cost of these assets is called the firm’s total capital requirement.
When we discussed long-term planning, we showed how the firm needs to develop a sensible strategy that allows it to finance its long-term goals and weather possible setbacks. But the firm’s total capital requirement does not grow smoothly and the company must be able to meet temporary demands for cash. This is the focus of short-term financial planning.
Figure 2.3 illustrates the growth in the firm’s total capital requirements. The
upward-sloping line shows that as the business grows, it is likely to need additional fixed assets and current assets. You can think of this trendline as showing the base level of capital that is required. In addition to this base capital requirement, there may be seasonal fluctuations in the business that require an additional investment in current assets.
Thus the wavy line in the illustration shows that the total capital requirement peaks late in each year. In practice, there would also be week-to-week and month-to-month fluctuations in the capital requirement, but these are not shown in Figure 2.3.
The three panels in Figure 2.4 illustrate this. Each depicts a different long-term financing strategy. The “relaxed strategy” in panel a always implies a short-term cash surplus. This surplus will be invested in marketable securities. The “restrictive” policy illustrated in panel c implies a permanent need for short-term borrowing. Finally, panel b illustrates an intermediate strategy: the firm has spare cash which it can lend out during the part of the year when total capital requirements are relatively low, but it is a borrower during the rest of the year when capital requirements are relatively high.
What is the best level of long-term financing relative to the total capital require-
ment? It is hard to say. We can make several practical observations, however.
1. Matching maturities. Most financial managers attempt to “match maturities” of assets and liabilities. That is, they finance long-lived assets like plant and machinery with long-term borrowing and equity. Short-term assets like inventory and accounts receivable are financed with short-term bank loans or by issuing short-term debt like commercial paper.
2. Permanent working-capital requirements. Most firms have a permanent investment in net working capital (current assets less current liabilities). By this we mean that they plan to have at all times a positive amount of working capital. This is financed from long-term sources. This is an extension of the maturity-matching principle. Since the working capital is permanent, it is funded with long-term sources of financing.
3. The comforts of surplus cash. Many financial managers would feel more comfortable under the relaxed strategy illustrated in Figure 2.4a than the restrictive strategy in panel c. Consider, for example, General Motors. At the end of 1998 it was sitting on a cash mountain of over $10 billion, almost certainly far more than it needed to meet any seasonal fluctuations in its capital requirements. Such firms with a surplus of long-term financing never have to worry about borrowing to pay next month’s bills. But is the financial manager paid to be comfortable? Firms usually put surplus cash to work in Treasury bills or other marketable securities. This is at best a zero-NPV investment for a tax-paying firm.
4 Thus we think that firms with a permanent cash surplus ought to go on a diet, retiring long-term securities to reduce long-term financing to a level at or below the firm’s total capital requirement. That is, if the firm is described by panel a, it ought to move down to panel b, or perhaps even lower.
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