Question

Before 2008 the trend towards short term financing was fuelled by a global surplus of cheap bank finance, however, the financial crisis put an end to this.

Arnold 2019

Required:

Outline the advantages and disadvantages of a company following an aggressive and conservative financing policy. And discuss how each of these policies might impact on its value. Describe two sources of short term finance (one bank source and one other) and evaluate the advantages and disadvantages of each source.

Answer 1

Aggressive Financing Policy

Aggressive Financing Policy uses short-term finance for financing short-term working capital. Infact it is also used to finance a portion of permanent (long term) working capital. In this policy there is high degree of risk involved as the current assets (cash, bank and receivables) are maintained only to a certain limit.

Advantages of Aggressive Financing Policy

1. Cost effective - This policy is cost effective as there are no ideal funds. All the funds are used to maximum advantage.
2. Cutting down unnecessary carrying costs - As the inventory is maintained only upto a certain limit, so there are no unnecessary carrying cost and cost of holding inventory.
3. Improves efficiency - This policy if successful is one of the best methods of managing working capital as there is an improved efficiency due to best use of resources.

Disadvantages of Aggressive Financing Policy

1. No cushion for sudden shock - Under this policy the company maintains only a limited amount of working capital. So the company has no safeguard against sudden abnormal losses or delays.
2. Risk of Insolvency - Under this policy company uses a part of short term funds to finance fixed assets. If these assets require regular payements to repay the installments.which is burden on the working capital. If the firm is not able to repay then there is a chance of liquidation.

Impact on value of firm

Aggressive Financing Policy has negative impact on profitability and value of company.

Conservative Financing Policy

Conservative Financing Policy uses long term finance for financing working capital. The firm maintains high degree of current assets and working capital. This policy does not involve much risk.

Advantages of Conservative Financing Policy

1. Smooth Operations - Since firm maintains high level of current assets and working capital so the firm can run smoothly. The firm is able to bear any abnormal losses or delays.
2. No risk of Insolvency - Since long term funds are used to finance fixed assets, there is no risk of inability of firm to repay the installments. The company has sufficient funds to pay for the liabilities.

Disadvantages of Conservative Financing Policy

1. Idle Funds - Long term funds are not utilized to the full extent. This funds thus remain idle and does not earn anything for the firm.
2. High carrying cost - Since the firm has to maintain high levels of inventory so the carrying costs and holding costs for the inventory are also high.
3. Ineffcient Working Capital Management - Many times funds are not utulized or remain under utilized. This leads to inefficient management of working capital.

Impact on value of firm

Conservative Financing Policy has positive impact on profitability and value of firm.

Sources of Finance

Bank Credit - Commercial Banks often provide short term finance ro the firm, it is called bank credit. When bank credit is granted the firm can draw the amount in installments or all at the same time.

Advantages

1. Bank credit is a flexible source of finance.
2. Bank loans are cheaper than other sources of finance.
3. Interest on bank loan is tax deductible.

Disadvantages

1. Banks follow strict repayment schedule.
2. The firm needs to have good credit worthiness to get loan from bank.

Trade Credit - Trade credit is the credit granted to the company in usual course of business by the suppliers/manufacturer allowing the firms to purchase the products without making an immediate payment.

Advantages

1. Trade Credit is easy source of finance. The firm can focus on other important aspects of the business.
2. It does not require immediate payment.

Disadvantages

1. New firms find it difficult to use this source of finance.
2. Only credit worthy companies can use trade credit.