Question

True or False: The ability of a firm to raise the sufficient capital under adverse conditions in order to sustain steady operations is referred to as financial flexibility

Answer 1

TRUE

Financial flexibility refers to a firm's ability to take advantage of unforseen opportunities or their ability to deal unexpected events depending on the firm's financial policies and financial structure. For example, a firm have high debt obligations and weak solvency (abilty to pay obligationas as they come due) and liquidity (abilty to turn assets into cash quickly) is not very financially flexible.

The accounting term financial flexibility is used to describe a company's ability to react to unexpected expenses and investment opportunities. Financial flexibility is usually assessed by examining the company's use of leverage as well as cash holdings.

Explanation

Companies with superior financial flexibility are both able to survive tough economic times as well as take advantage of unexpected investment opportunities. Companies that are unable to respond adequately to unforeseen setbacks may lack the resources to survive longer-term economic downturns.

While the exact measure of financial flexibility may vary among analysts and investors, universally accepted categories of flexibility include:

• Leverage: the use of debt to increase the total profits returned to the company's equity holders.
• Cash Holdings: includes paper money, coins, checks, money orders, and money on deposit with banks.

The most common measures of leverage include:

Debt Ratio = Total Liabilities / Total Assets

Debt to Equity = Total Liabilities / Owner's Equity

As the above ratios increase, the risk associated with financial hardships grows. High ratios can also limit the company's ability to borrow, thereby lowering the company's financial flexibility. When drawing conclusions about the relative performance or risk of a company, benchmark comparisons should be made with competitors in the same industry