The CFO's Need:
Match The Maturities Of Current Assets With The Financing Mix To Avoid Duration Mismatches

The need for working capital does not come to an end once the operating cycle is completed. To carry on a business, a minimum stream of working capital is necessary for a smooth production flow. That minimum level is known as the core, or permanent, working capital. Variations in working capital requirements over and above the core level reflect seasonal variations, and unpredictable day-to-day or month-to-month variations.

Both core and variable working capital are supported by a mix of spontaneous current liabilities (trade credit and provisions for taxation), short-term financing (bank finance and short-term marketable securities), and long-term financing (long-term debt and equity). Since trade credit and accruals for tax payments are determined by exogenous factors, the crucial aspect for any working capital financing strategy is determining the proportion of current assets that is to be funded by short-term sources of finance.

A conservative current asset financing strategy would keep that proportion low. Rates are then locked in for a longer term, dispelling the uncertainty associated with frequent refinancing. The price of this strategy is higher financing costs since long-term rates will normally exceed short-term rates. A more aggressive strategy would boost the bottomline, but the firm runs the risk that its current asset portfolio may not churn out cash-flows fast enough to service its rapidly-maturing obligations. Warns P.B. Desai, 52, vice-president of the Rs 516.09-crore United Phosphorus: "Duration mismatches can create all kinds of cash-flow problems."

THE STRUCTURED SOLUTION: It is a cardinal principle of corporate finance that long-term assets should be financed by long-term sources and short-term assets by a mix of long- and short-term sources. Therefore, a hedging strategy would match each current asset with a financing instrument of, approximately, the same maturity. So, short-term or seasonal variations--less trade creditors and provisions--should be financed by short-term debt. The core component of current assets, however, should be financed through a mix of long-term debt and equity.

However, depending on their perception of interest rate movements, CFOs can tweak this basic formula to minimise interest costs. For instance, if you believe rates have plateaued and will edge upwards, lock in these rates by increasing your reliance on long-term sources of finance. Agrees anz Investment Bank's Kapoor: "When there is excess liquidity in the system, CFOs should meet their working capital requirements through medium- to long-term paper." Conversely, if the tight liquidity situation in the economy has caused rates to surge, consider financing even the permanent component through frequent roll-overs.

DEPOSITS. This is a peculiarly Indian innovation. There is no international parallel to either the Inter-Corporate Deposit (ICD) or the Public Deposit. Developed as an alternative to bank finance, the deposit route offered everything a rigid banking system could not: speed, flexibility, the absence of government regulation. Goods did not have to be hypothecated to obtain funds, rigid limits were not set, and the range of maturities allowed the CFO to tailor the deposit to suit his duration preferences.

While there will always be room for instruments that supplement, and even substitute for, an inadequate banking sector, the share of deposits in the financing pie will diminish by 2000. As debt-market activity picks up pace, investors and issuers will switch to more marketable instruments: CPs and short-term debentures. Already, corporates have been allowed to park their short-term surpluses in money market instruments. Expect an increasing number of issuers as well as instruments. Points out Vivek Jetley, 38, group vice-president, (finance) of the Rs 113.37-crore Max India: "If brokerage and servicing costs are factored in, deposits, especially public deposits, don't come cheap."

Marketable instruments are also safer. Since the market for deposits runs largely on the oxygen of credibility, it is prone to dramatic deflations; ICD volumes have still not recovered from the spate of defaults that ripped through the market in 1995-96. And the damage done to public confidence by the CRB Capital Markets debacle may take even longer to repair. The lesson for the CFO: although deposits can be of varying maturity structures, they work best as short-term bridging instruments and not as a regular funding source.

A frenetic burst of innovation will be the dominant characteristic of working capital finance in the next millennium. There has already been a revolution in the equity markets, and we are in the midst of a bustling expansion of debt markets. Yet, as bank finance was simply the be-all and end-all of working capital finance, short-term financing strategies remained static. No longer; the forces unleashed by incremental reforms over the past six years are freeing the price of capital, and the interlocking money markets. For the CFO, the long-awaited big bang in the working capital market may finally be here.