Short Term Financial Policies
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, …show more content…
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.
Total Cost of holding current assets
Amount of current assets (CA)