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:

3. Outline the advantages and disadvantages of a company following an aggressive and a conservative financing policy. And discuss how each of these policies might impact on its value.

(8 marks)

2. Describe two sources of short term finance (one bank source and one other) and evaluate the advantages and disadvantages of each source.

(8 marks)

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

(4 marks)
Total 20 marks

Answer 1

Aggressive Approach of Financial Strategy - The aggressive approach is a high risk strategy of working capital financing where in short term finance are utilized not only to finance the temporary working capital but also a reasonable part of the permanent working capital . A major part of Seasonal requirement or temporary working capital is financed by short term source of finance . In this approach , the difficult area is the part of permanent working capital which is financed by short term sources . it could have been problem of liquidity and bankruptcy to the firm .

Advantage of Aggressive Strategy of working capital – lower financing cost with High Profitability. In this strategy, the cost of Interest is low because of teh maximum usage of short term finances .

Also Lower carrying and Handling cost – Lower level of Inventory makes th carrying and holding cost also go down and that directly affect the profitability

Highly efficient working capital management

Disadvantage – Insolvency Risk and Lost opportunity and unexpected shocks

This strategy faces the high level of insolvency risk because the permanent assets are financed by the short term financing sources . Also there is no cushion or margin in this strategy if financing , sudden big contracts of sales are not possible to execute

Conservative Approach – Advantage and disadvantage – The advantage of a conservative approach are the lowest re investment and Interest rate risk among the other working capital financing strategies . Moreover, it results in a higher level of liquidity and solvency , so such business can easily access short term borrowing to cover emerging needs in working Capital

Lowest risk tends to lowest profitability because long term financial usually has a higher cost than short term financing . Funding temporary working capital by long term financing also leads to the fact that business have interest expense .

Two Source of Short term finance includes – 1) Trade Credit 2) bank credit ( include Loans and advance , cash credit etc)

Advantage of Trade credit – Increased sales , customer loyalty , competitive advantage . Increased in Sales mean – a customer will buy more of suppliers product if they do not have to pay cash immediately for their purchase A seller who is able to offer trade credit to buyers has an advantage over his competitor.

Major disadvantage – Negative effect on Cash flow – the most immediately effect of trade credit is that sellers do not receive cash immediately for sales.

Must investigate Credit worthiness of customers . Monitoring account receivable plus possibility of Bad debt

Two Source of Short term finance includes – 1) Trade Credit 2) bank credit ( include Loans and

Bank Loan – Advantage of term loan – the loan is not repayable on demand and so available for the term of the loan

Loan can be tied to the lifetime of the equipment or other assets – borrowing the money to pay for

While pay Interest on loan , do no have to give the lender a % of profit

Interest rate may be fixed for the term

Disadvantage – Larger loan will have certain terms and conditions that must be adhere . It could have trouble cash flow problem

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

1. Right for fair valuation of assets – Bank has to issue a notice specifying the fair value of the asset along with reserve price , date and the time of auction. This is calculated by the valuers of the Bank

Right to adequate Notice – The borrower account is classified as a non performing asset ( NPA) if the repayment is overdue by 90 days . If the borrower fails to repay within the notice period , the bank can go ahead with sale of assets “ .