The more of the funds of a business are invested in working capital, the lesser is the return in terms of profitability and the less amount is available for investing in long-term assets such as plant and machinery, etc. Therefore, the corporate enterprise has to minimize investment in working capital and concentrate on investment of resources in fixed assets. Some economists argue that current assets be financed by current liabilities. But this all depends upon economic conditions prevailing in the economy at a particular time requiring a company to keep business resources liquid so that business can take immediate advantage of knocking opportunities. In short-run, the opportunity may arise for investment in stocks to make immediate gains due to movement in prices, whereas investment in plant and machinery may not be possible.
The finance manager is required to determine the optimum level of current assets so that the shareholders’ value is maximized. A firm needs fixed and current assets to support a particular level of output. As the firm’s output and sales increase, the need for current assets also increases. Generally, current assets do not increase in direct proportion to output; current assets may increase at a decreasing rate with output. As the output increases, the firm starts using its current asset more efficiently. The level of the current assets can be measured by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives the current assets/ fixed assets ratio. Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy, and a lower current assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant. A conservative policy implies greater liquidity and lower risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies. The current assets policy of most of the firms may fall between these two extreme policies. The following illustration explains the risk-return trade-off of various working capital management policies, viz., conservative, aggressive and moderate.
Thus, the current assets represent cash or near cash necessary to carry on business operations at all times. A level of current assets is thus maintained throughout the year and this represents permanent working capital. Additional assets are also required in business at different times during the operating year. Added inventory must be maintained to support the peak selling period when receivables also increase and must be financed. Extra cash is needed to pay increased obligations due to spurt in activities.
Fixed assets financing is different from current assets financing. In fixed assets investment is made in building, plant, and machinery which remains blocked over a period of time and generates funds through the help of working capital at a percentage higher than the return on investment in current assets. Working capital financing or current assets financing is done by raising short-term loans or cash credits limits but fixed assets financing is done by raising long-term loans or equity.
The working capital leverage and the capital structure leverage are, therefore, two different concepts. Capital structure leverage is associated with the fixed assets, financing, with an optional mix of owner’s funds and borrowed funds. Owner’s funds are the internal funds of the company comprised of equity holder’s money in the shape of equity, retained earnings, depreciation fund, and reserves. Borrowed funds are the external sources of funds raised from banks, financial institutions, issue of debentures, stock, and term deposits from the public. Financing of fixed assets with borrowed funds is cheaper than using owner’s funds which increases the earnings per share and tends to increase the value of the owner’s capital in the share market.