In order to deal with its working capital needs, a government must know how much current liabilities it will require to finance its current assets. For most governments, the amount of current liabilities is restricted by the amount of resources they have committed in accounts payable, notes payable, accruals and, to some extent, in transfers to other funds and governments. Lenders such as banks and other financial institutions that provide short-term loans to governments, do so to allow them to finance temporary or seasonal buildups of receivables and inventory. They usually do not allow these funds to be used to finance long-term needs. What is needed, therefore, is a set of measures that a government can use to adequately finance these needs.
There are four basic measures, or policy choices, available to a government to determine an appropriate mix of short-term and long-term financing: (1) matching policy, (2) aggressive policy, (3) conservative policy, and (4) balanced policy. Understanding these policies are crucial, since they serve as the foundations of working capital management.
13.4.1 Matching Policy
One of the oldest policies in finance, which also applies to government, is based on a principle called the matching principle. According to this principle, an organization must finance its short-term needs with short-term sources (such as short-term borrowing) and long-term needs with long-term sources (such as long-term debt). It is called the ‘‘matching principle’’
because the objective is to ‘‘match’’ the maturity of the sources of funds to the length of time the funds are needed.
The underlying logic behind this is quite simple: the matching principle produces lower risk and lower financing cost for an organization in the long run. For instance, if a government finances its long-term needs with short- terms funds (such as short-term borrowing), chances are that it will have to refinance (re-borrow) its short-term debts as they become due. This will add to the total cost of financing from additional transaction costs (such as legal fees, lender fees, etc.) plus a likely cost increase from higher interest rates at which the government will have to re-borrow. On the other hand, if the government finances short-term needs with long-term funds (such as
long-term debt), it is likely to produce excess funds that it may have to invest in low-yielding securities. The matching principle corrects this problem by making sure that the maturity date of financing (i.e., borrowing) roughly matches the duration of the asset being financed. In other words, funds borrowed to finance an asset should be repayable at roughly the time of the asset’s acquisition or construction, which will make the debt-asset combination self-liquidating, another term used for matching principle.
Figure 13.2 illustrates the essence of this principle.
To give an example, suppose that a government plans to construct a project that would cost $5 million today, but would pay $6.5 million a year from now. Following the maturity matching principle, the government can take out a loan to the amount of $5 million for twelve months (assuming borrowing is the only option available to the government) and use the project’s proceeds to pay off the loan. To borrow for a period longer than twelve months would leave unused funds which will continue to draw interest even after the completion of the project. On the other hand, borrowing for a period shorter than twelve months will result in additional borrowings, which will increase the costs of transaction and other costs, thereby adding further to the total cost of borrowing for the government. It makes sense, therefore, to match the duration of short-term projects with the maturity of the finances supporting them and long-term projects with long- term debt that lasts for a long time, usually 15 to 30 years, or more.
13.4.2 Aggressive Policy
Matching policy works as long as an organization finances its short-term needs with short-term resources and long-term needs with long-term sources, but there are circumstances when a management has to pursue a policy that is aggressive. Under an aggressive policy, an organization will Figure 13.2 Financing working capital: matching policy (General Fund Operations).
Working Capital Management in Government: Basic Concepts and Policy Choices g 347
finance its seasonal needs as well as some of its permanent needs with short- term funds. This is shown in Figure 13.3.
Using short-term funds to finance a government’s short-term needs as well as some of its permanent needs is relatively inexpensive, but it is also risky. It is relatively inexpensive because the rates for short-term borrowings are usually lower than long-term rates; therefore, it will cost a government less to use short-term funds to finance its working capital needs.
The risk comes from the fact that to finance the portion of permanent needs a government may have to re-borrow, which means that every time a new loan is used the government is likely to face a new set of financial conditions that may be more demanding than the conditions for the initial loans.
For instance, the government may have to re-borrow at a higher rate than what it would have paid if it had financed the needs with long-term debt in the first place. In the short-term, however, it reduces costs to the government.
We can look at Table 13.2 to illustrate this. Under the aggressive policy, according to the table, the government will need to borrow an average of
$5,580,858 to meet its seasonal needs for funds, and an average of
$25,481,500 to meet its permanent needs. Let us say that the annual cost of short-term funds needed by our government is 3.5 percent, and the annual cost of long-term financing is 8.9 percent. The total cost of financing under the aggressive policy, therefore, will be $2,463,183.53; that is,
0:035$5,580:858
ð ị ỵð0:89$25,481,500ị ẳ$2,463,183:53ị The aggressive policy operates with minimum net working capital, since only the permanent portion of the current assets is financed with long-term funds. For our hypothetical government, the level of net working capital used for this purpose is $3,692,000, which is the amount of permanent Figure 13.3 Financing working capital: aggressive policy (General Fund Operations).
current assets, obtained by subtracting the fixed assets for the month of June from the permanent funds requirement for the same month ($25,481,500
$21,789,500ẳ$3,692,000). The policy is risky because the amount of net working capital is the lowest and also because the government may need to draw heavily on its short-term funds to meet its seasonal needs.
13.4.3 Conservative Policy
A conservative policy is the exact opposite of an aggressive policy. Under the conservative policy, a government uses long-term funds to finance its permanent needs, as well as a portion of its seasonal needs. This is shown in Figure 13.4. As can be seen from the figure, short-term funds support only the very tip of the seasonal working capital. When long-term funds are used to finance permanent, as well as some seasonal needs, it produces excess funds for governments that can be invested in short-term securities. This ensures that funds are available at all times to meet the working capital needs of a government. Since there is very little possibility of running out of funds, it will produce very little risk for the government; hence the term
‘‘conservative’’ policy.
Although less risky than an aggressive policy option, the conservative policy costs more, since it uses long-term funds which are more costly to start with. To provide an example, let us go back to Table 13.2. Let us say that the annual cost of long-term funds is 8.9 percent, as before. Since the average long-term financing balance under the conservative policy is
$35,521,000, which is the month of December when the demand for services is at its peak, the total cost of financing under this policy will be
$3,161,369.00 (0.089$35,521,000). When compared with the figure for the aggressive policy, it clearly indicates that the conservative policy costs more by as much as $698,185.47.
Figure 13.4 Financing working capital: conservative policy (General Fund Operations).
Working Capital Management in Government: Basic Concepts and Policy Choices g 349
Unlike the aggressive policy, the conservative policy operates with maximum net working capital, since both the permanent and the temporary portion of an organization’s current assets are financed with long-term funds. For our hypothetical government, the level of net working capital of $13,731,500 is the highest for the month of December (the peak period), which is obtained by subtracting the fixed assets for the month from the total assets (i.e., long-term financing) for the same period. The $13,731,500 of net working capital also indicates a low level of risk for the government.8
13.4.4 Balanced Policy
Both aggressive and conservative policies offer choices that are some- what extreme. The aggressive policy, while relatively inexpensive, entails a lot of risk. The conservative policy, on the other hand, is safe, but costly.
Since most practitioners are risk avoiders,9 they would prefer a suitable compromise between the matching principle and the conservative policy.
If one is willing to accept the conventional wisdom that short-term interest rates are lower than long-term rates and also the expectation that cost advantage of short-term borrowing will not be fully offset by interest income from short-term investment of excess funds into marketable securities, a balanced policy would be most appropriate.
Under the balanced policy, a government is expected to maintain sufficient net working capital and long-term funds to meet permanent as well as seasonal needs. The government should use short-term funds, but not all the credit available to it, to cover part of the peak seasonal needs. As the seasonal needs are reduced, it can pay off its short-term obligations (borro- wings) and then invest the excess funds into short-term marketable securi- ties during the period of low seasonal needs. The advantage of this policy is that it provides a safety factor to cover unexpected seasonal needs using short-term funds that have not been planned. If, for instance, the current- asset liquidation (i.e., disposing of current assets) turns out to be less than expected, the government will still be able to pay off its short-term obli- gations (loans), although less funds will be available for investments. On the other hand, if a credit problem emerges, the government will probably have to pay a higher than expected interest rate on short-term borrowings, but will not run the risk of not having short-term credit available.