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Hello. I’m a confused with working capital financing policies. For example, a moderate policy implies that all of the non-current and permanent current assets should be financed by long-terms sources. But I think it also implies liquidity ratios to be abnormally high.
Say a company have $10 m of PPE, $5 of permanent current assets and $1 m of fluctuating current assets. Those current assets are financed by shareholders’ funds of $12, $3 m of long-term loan and $1 m of payables. Thus, all of the non-current assets and permanent current assets are covered by long-term finance. But the current liquidity ratio is 6 ((5+1)/1). Could you explain me this, please. It seems contradictory to me now.But there is no contradiction 🙂
The more conservative the policy is then the greater will be the current ratio and therefore there is less risk (which is the advantage of a conservative policy).
The more aggressive the policy, then the lower will be the current ratio and therefore there is more risk.
The ‘downside’ of a more conservative policy is that there will be more interest payable (because you are borrowing money that is not always needed) whereas a more aggressive policy will mean paying less interest because you are only borrowing money when it is needed.
Have you watched my free lectures on this? The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Thank you for the reply.
I think a current ratio of 6 is too high, isn’t it?
If the current ratio of the company is 1.2, than 83% of the current assets are financed by short-term sources. It seems to be an aggressive financing poilicy. But it is the benchmark the current ratio to be not less than 1 (if inventories are not slow-moving).
6 is certainly rather high, but there is no standard current ratio (apart from it being more than 1, otherwise there are major liquidity problems) – it very much depends on the type of business and you could only really state that it seems too high (or low) by comparing with similar businesses.
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