Model for Financing Current Assets
In this chapter, we addressed the topic of working capital management, and now we will discuss the policies set for
finance working capital.
Using short-term financing to support the firm's productive assets has both advantages a
An aggressive policy entails heavy reliance upon short-term debt, while a conservative policy woul
for less use of short-term debt.
At first glance, short-term debt financing offers firms greater speed, more flexibility, and generally lower interest r
However, short-term financing still carries a risk.
Long-term financing allows firms to lock in an interest expense,
whereas short-term financing can expose a firm to a wildly fluctuating interest expense.
Over reliance on short-ter
debt could quickly lead to default if a substantial recession should hit.
The major sources of short-term debt financing are short-term bank loans (notes payable), accruals, and trade cre
Accounts payable, or trade credit, is the largest single category of short-term debt on the balance sheet, representin
approximately 40 percent of the average nonfinancial corporation's current liabilities.
Accounts payable, like accr
is a spontaneous liability because it generally experiences corresponding growth to a firm's productive assets.
credit policy tells us the terms by which they allow customers to purchase goods on credit.
For example, Microchi
Electronics' credit policy is on terms of 2/10, net 30.
This is interpreted as a 2% discount if paid within the first ten
days, but the full invoice amount is due within 30 days if the discount is not taken.
If we are told that Microchip's
annual purchases are $11,923,333, we can calculate the firm's average daily A/P.
(We will use a 365-day accountin
Annual chip purchases
From the firm's trade terms, we also know the following:
Discount period (in days)
Days until due
If Microchip's customers decide to take advantage of the discount, the average accounts payable can be determine
multiplying the daily accounts payable by the discount period.
However, if the firm's customers decide to not take advantage of the discount, we assume that they will take the fu
to pay off the debt.
We can determine the average accounts payable under this scenario, too.
Average A/P (w/o discount)