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. Discuss two ways that banks can try to protect themselves from the risk of non-payment of interest or capital.

Answer 1

Advantages of a company following a conservative financial policy

• In this strategy, the level of working capital and current assets (inventory, account receivables and most important liquid cash or bank balance) is high.
• A high level of inventory absorbs a sudden surge in product sales, production plans, any unusual delays in purchase time, etc., it receives a high level of customer satisfaction and smooth operation of the company.

Advantages of a company following an aggressive financial policy

• In this strategy, due to the maximum use of short term finance, the cost of interest is low. There are two reasons for this:
• First of all, the rate of interest is cheap and secondly, in the off-season, the loan can be repaid and therefore, there are no passive funds. If the operating cycle is running smoothly, then it is called the most effective working capital management.

The disadvantages of an aggressive financial policy

• A possible lack of liquidity is the most significant risk.
• No cash is maintained in reserve to cover any unexpected needs in working capital, which must be financed by immediate borrowings.

The disadvantages of a conservative financial policy

• The lower risk of a conservative strategy also results in reduced profits because of the higher interest rate costs of long-term debt.
• Managers who are risk-takers are more comfortable with an aggressive financing strategy. It is the most profitable method of managing working capital, but it comes with the most risk. The conservative approach is less profitable but has the least risk.

The two sources of short term loan finance

(i) Trade Credit

(2) Bank credit including loans and advances, cash credit, overdraft and discounting of bills

(3) Customers' advances

Advantages of Short-Term Loans

Fast Approval - A short-term loan is suitable for people who need quick access to cash. Just like a payday loan, a short-term loan application can be approved within a few hours depending on the lender. In some cases, you will have access to the funds within the same day or the following business day.

You Pay Less Interest - Typically, the longer you owe the lender, the higher the interest you will pay. However, with a short-term loan, you will be paying back everything within a shorter period which means you pay less interest as well. You will still save some money even if the interest rate is higher compared to that of long-term loans.

Disadvantages of Short-Term Loans

They are High-Cost Loans -Typically, short-term loans attract high-interest rates and high monthly payments. Since you are financing the principal debt over a shorter period, you may end up paying a significant amount of money every month compared to what you will pay if you are servicing a long-term loan.

It Can Have a Negative Impact on Your Credit Score - Although you can use a short-term loan to build your credit score, the consequences can be dire if you fail to repay it on time. Your new debt to income ratio plus the high-cost new loan will drastically bring down your credit rating.

The two ways that banks can try to protect themselves from the risk of non-payment of interest or capital.

Reduced Faulty Lending Decisions - An internal communications program that includes educational components based on your credit risk and conversation skills training reduces poor lending decisions that lead to financial losses. Your institution should include an employee newsletter or blog, podcasts or videos, and an employee forum in the program.

Increased Employee Confidence - Robust internal communications programs are as much about building employees’ confidence in their understanding of credit policies as they are about conveying information. Do not only send missives or directives to your team; instead, consistently encourage two-way conversations.