Sales create a ripple effect throughout the business. A sale can result in a rise in accounts receivable, a need to restock certain inventory and an increase in outstanding supplier invoices. The size and rate of these changes are strategically important because they affect how much external financing a business needs to maintain its working capital.

Changes in current assets

When a business experiences a rise in sales, it sets off a chain reaction. If more customers are buying on credit, accounts receivable (AR) will grow, and more inventory will be needed to keep up with demand — both raw materials and finished goods. All this growth needs to be funded.

This could mean tapping into the business’s cash reserves or taking out some short-term loans. If the rise in sales appears to be long term, you will want to keep more cash and liquid investments on hand to match the increased scale of operations. Of course, this works in reverse too. If sales decrease, most of your current assets will shrink accordingly, though inventory might temporarily spike while you adjust production to match the new reality.

Changes in current liabilities

Liabilities and assets are connected (assets = liabilities + equity). When liabilities decrease, assets (e.g., cash) must be decreased, or other liabilities (e.g., taking out a loan to pay off the liability) must be increased to restore balance. 

When business is good and sales are up, more materials will need to be purchased from suppliers. Buying the supplies on credit (as most businesses do) causes your accounts payable to increase. Additionally, more production means more wages to pay (accrued wages). Plus, higher profits mean a bigger tax bill (accrued taxes).

As an organization pays off outstanding obligations to vendors or suppliers, accounts payable (AP) decreases. This is achieved by using cash (asset decreased) or borrowing (increase in another liability).

This also works in reverse: When sales decrease, taxes and the need for materials and labor decrease, which causes a decrease in related liabilities, e.g., accrued wages and accrued taxes.

External financing requirements

When a business expands, more working capital is needed to support operations. Profits may feed some of this growth through retained earnings; however, that is often not enough to fund the full cost of the expansion. If that is the case, financing will need to be secured from outside the organization, which is generally achieved through debt or equity investment, assuming no significant changes occur in regard to the company’s long-term assets or liabilities.

When business declines and your current assets shrink (e.g., less inventory, fewer outstanding customer bills), cash is freed up. However, if AP and/or similar liabilities (e.g., wages, taxes payable) drop below assets, debt in the form of a loan will likely need to be acquired to maintain balance.

Current asset investment strategies

As a treasury professional, you have two key decisions to make: 1) the amount of working capital your business needs and 2) the best way to finance that working capital. These decisions must be made together as each aspect relies directly on the other.  Two other elements that come into play when making these decisions are the firm’s operating needs and management’s risk tolerance.

Restrictive current asset investment strategy

A restrictive current asset strategy equates with running a “lean” operation. Current assets (e.g., inventory, AR, cash) are kept at minimal levels compared to sales. It also mandates tight inventory controls, strict requirements as to who gets credit and maintaining low cash reserves.

The upside is that there is the potential for better profits. Borrowing less means lower borrowing costs and less lost interest on cash holdings. The downside is that this strategy is risky. The business could run out of inventory, turn down sales due to strict credit requirements or find itself short on cash when it’s needed most.

Relaxed current asset investment strategy

This is essentially the inverse of the restrictive strategy. With the relaxed current asset investment strategy, cash, inventory and AR are maintained at higher levels than your sales volume. Credit policies are less restrictive, and inventory is not kept under such tight controls.

There is always a trade-off, and with this strategy, your returns will likely be lower because more cash is tied up in these assets. In terms of day-to-day operations, it’s a much safer way to do business; however, if your sales suddenly decrease significantly, having your money tied up in current assets could cause cash flow issues.

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Current asset financing strategies

Decisions regarding how to finance permanent and fluctuating current assets define the working capital financing strategy. Every business has a baseline level of current assets needed to keep the lights on, i.e., the permanent current assets. To find this number, review the balance sheets for the past few years and find the lowest level of current assets carried; everything above that baseline is the fluctuating current assets.

The financing strategy generally employed is to use long-term debt to finance permanent working capital needs and short-term debt (e.g., credit lines) to finance fluctuating working capital. Using short-term debt to cover fluctuating needs provides you with a level of flexibility, which helps minimize excess financing and avoid paying unnecessary interest.

Always try to secure a multi-year revolving credit agreement, otherwise you will have to renew it annually. While some companies prefer longer-term debt for the security it provides, it can also mean excess financing and paying unnecessary interest.

The decision depends on two primary factors: 1) management’s risk tolerance and 2) the cost differential between short- and long-term borrowing. Treasury professionals need to keep up with trends in money markets and capital markets, as they will need to advise leadership on whether it is best to go short-term through banks or money markets, or to lock in longer-term rates through term loans or capital market funding.

Approaches to financing current assets are classified as maturity matching, conservative and aggressive.

Maturity-matching finance strategy

The maturity-matching finance strategy is a straightforward approach that aligns financing with the business’s needs. Long-term financing (debt and equity) is used to cover fixed assets and the baseline level of current assets.

Short-term financing, like a credit line, is used on an as-needed basis. When more working capital is needed, you draw on the credit line. When your needs lessen and cash is freed up, it is paid down. This method provides a flexible financial cushion that supports the business’s changing needs.

Conservative financing strategy

With a conservative financing strategy, long-term financing is used to cover fixed assets, permanent current assets and (typically) the average level of fluctuating current assets. Short-term financing is only used when fluctuating assets go above the average. You use less short-term debt with this strategy, which is why it is labeled “conservative.”

The trade-off is that because you’re carrying long-term debt, even in times when it is not needed, you will likely have higher financing costs. This shows up as a stronger current ratio, which is good, but it may result in extra interest expense, eating into your profits.

The key is to lock in fixed rates on your long-term debt while maintaining floating rates on your short-term debt. Doing this can protect against interest rate swings.

Aggressive financing strategy

With an aggressive financing strategy, long-term financing (debt and equity) is used for fixed assets and part of your permanent current assets. The rest of the permanent current assets and all fluctuating needs are funded with short-term debt.

Since short-term rates are typically lower than long-term rates, this is the most profitable strategy — in theory. It also means you are taking on significantly more liquidity risk in the following ways:

• Rollover or refinancing risk
• Greater exposure to interest rate swings
• More frequent renewal costs and fees
• The need for alternative financing if your lender requires an annual "cleanup" period

You have to look at the big picture with this strategy. What if there is a recession or the competitive landscape changes? If that happens and sales decrease, inventory isn’t moving as fast, customers are slower to pay and AP is being stretched. At the same time, you need to renew your short-term financing, only now the business looks riskier. The bank may require higher rates or choose not to renew your credit at all — just when it’s needed most.

Weighing the trade-offs of different strategies

The current asset investment and financing strategies you choose must consider several factors, including management’s risk tolerance, sales stability and predictability, lender concerns, the interest rate environment, availability of funds and supplier reliability.

Industry practices should also come into play when choosing a strategy. For example, if you’re in a high-margin industry, a liberal credit policy may be a good idea, as the profits from increased sales could outweigh the costs of carrying more receivables and dealing with bad debt. That said, this option only works if the profits from the increase in sales are greater than the costs.

Weighing the trade-offs of the different strategies is critical to selecting the best approach for your company. Getting this decision right can give you a competitive advantage; getting it wrong can put your entire operation at risk.

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