In: Finance
How does the organization “manage” the short-financing needs of the organization? How do working capital policies affect the short-term financing needs of the organization? Should all short-term assets such as accounts receivable and inventory be financed with short-term financing? Why or why not?
How does the organization “manage” the short-financing needs of the organization?
The short term financing needs are provided out of short term credit products. They are
Cash Credit – the inventories are mortgaged by the bank and based on the valuation every month the bank provides a drawing power to the organisation and charges interest on the amount used. The charge here is inventories.
Bank Overdraft – this allows the organisation to overdraw the account more than the balance it has got. This may be secured or unsecured.
Receivables Financing – based on the credibility of the debtors the banks may finance the receivables of the organisation. For example – if company ABC Ltd. has a receivable from Apple LTd. to the tune of 1 million dollars then the bank may agree to receive the amount from Apple and provide the ABC Ltd. with an amount equal to 0.98 million dollars thereby keeping 0.02 million dollars as banks interest income.
How do working capital policies affect the short-term financing needs of the organization?
The working capital policies are defined basically as conservative or aggressive. The conservative policies tell that the organisation should carry more liquidity (cash) to take care of short term liabilities without any sort of delays. This approach would mean keeping more cash in the organisation and letting go off other profitable short term investment opportunities.
The aggressive approach tells to keep less liquidity in the organisation and keep the extra sum in short term investment opportunities. Thus here the organization would delay its payments to creditors.
Thus based on any of the two approaches above the short term financing needs would be planned by an organisation.
Should all short-term assets such as accounts receivable and inventory be financed with short-term financing? Why or why not?
The answer to the above question is Yes. This is called the matching concept. The payments time horizon should be matched with the asset receivable time horizon to avoid any soft of liquidity crunch.
The best example in this case is Daewoo Motors which utilised short term funds for long term investments and was trapped in liquidity and was ultimately wound up.
Both account receivable and inventory are short term assets and if they are financed with long term then the organisation will have surplus liquidity on recovery of the same. The surplus liquidity will then have to be parked in a suitable short term investment opportunity.
Only difference here is that the long term requirement of the working capital into these assets should be financed with long term capital as its never going to be recovered from the business. Its only chance of recovery is when the business is closed down.