Short Term Financial Policies

1229 words 5 pages
PTMBA I / Trim III (A. Y. 2010-11) Div. C.

Assets of Short Term Financial Policy

Flexible Short Term Financial Policy

Maintainance of high ratio of current assets to sales. This would include:-

❖ Keeping large cash & bank balances ❖ Making substantial investment in inventories. ❖ Liberal Credit Term meaning high level of debtors.

Restrictive Short Term Financial Policy. This would include:-

❖ Low cash balances / no investment in marketable securities ❖ Small inventory level ❖ No credit on Sales & hence receivables at minimum

Thus, flexible short-term financial policies are costly in that they require higher cash outflows to finance cash and marketable securities, inventory, and accounts receivable. However,
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Because this approach implies chronic short-term cash surpluses and a large investment in net working capital, it is considered a flexible strategy. When long-term financing does not cover the asset requirement the firm borrows short-term to make up the deficit. This is restrictive strategy.

Which Is Best?

What is the most appropriate amount of short-term borrowing? There is no definitive answer. Several considerations must be included in a proper analysis:

1. Cash reserves: The flexible financing strategy implies surplus cash and little short-term borrowing. This strategy reduces the probability that a firm will experience financial distress. Firms may not need to worry as much about meeting recurring short-term obligations.

2. Maturity hedging: Most firms finance inventories with short-term bank loans and fixed assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent financing and is inherently risky because short-term interest rates are more volatile than longer rates.

3. Term Structure : Short-term interest rates are normally lower than long-term interest rates. This implies that, on average, it is more costly to rely on long-term borrowing than on short-term borrowing.

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Total Cost of holding current assets

Shortage costs

Amount of current assets (CA)

Carrying

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