Short-Term Financing of Working Capital

Figs. 1.2, 1.3, 1.4 and 1.5 showed a typical asset structure of a firm and of its possible financing. Using long-term finance solely is the most conservative as regards the certainty of finance but it is probably the most costly in terms of interest rates and in creating surplus cash. At the other extreme, using solely short-term finance runs the risk of the finance not being renewed and of the very possible consequent bankruptcy. Short-term relates to finance that is typically repayable within one year; medium and long-term finance is that which typically extends beyond one year, e.g. debentures, preference shares, ordinary shares, retained earnings. In between these two extremes lie a host of financing strategies which a company can adopt. One, which was depicted in Fig. 1.3, is to finance the permanent segment of the current assets by long-term capital and the fluctuating current assets by short-term capital ; of course, this involves recognising the ‘permanent’ element of current assets. In practice, most firms adopt a policy of financing some part of their current assets by long-term finance ; the traditional textbook solution is that one-half should be financed in this way (the current ratio being 2·0; this ratio is described in Chapter 6). Specific industries have variations on these figures of course.