Question

what is the nature of financing policy (10marks)

Answer 1

Meaning of financing policy:-

Financing Policy refers to the decisions, choices or regulations related to the financial system of the organization like payment system, borrowing system, lending system etc. The policies are framed to introduce financial stability, promote market efficiency and enhance the value of the firm for its stakeholders.

The cost of financing for long-term is always higher than the short term. However, the risk in short-term financing is always greater. The financing policy of the organization determines the type of borrowing which business should opt for.

Types of financing policy:-

1. Hedging policy:-

Hedging policy involves offsetting the finance for an asset with a liability that matures on the expected life of the asset. For example, a business wants to purchase machinery having an expected life of 20 years. It can do so by financing the asset by a 20-year loan. This way the asset and liability both will mature at the same period. The purpose of hedging policy is to match the assets and liabilities during the relinquishing period.

2. Conservative policy:-

An organization’s attempt to match the assets with the liabilities is not always possible. In such situations, the business uses conservative financing policy. In this policy, the firm uses more of long-term sources of finance and less of short-term finance to purchase its asset. The business acquires the permanent and current assets using long-term sources of finances. Only a part of short-term finance is used to finance its temporary current asset.

3. Aggressive policy:-

Aggressive financing policy comprises of relying more on short-term sources of finance then long-term sources. It is termed as aggressive policy because it is riskier as it involves the continuous renewal of the borrowing. In this policy, the firm finances its permanent current assets using the short-term sources of finance.

4. Highly aggressive policy:-

A highly aggressive financing policy is one where the major part of the permanent asset is financed by long-term sources and a minor portion is financed by short-term sources. It is a common assumption that the firms which follow this policy are nearing their closure and are termed as “sick”.

Depending upon the strategy and requirements of the organization, it can adopt different types of financing policy. However, there are different aspects that businesses should consider while taking decisions relating to financing policy.