Question

1.(a) If the carrying cost is high and shortage cost is low, what type of current asset policy is more appropriate for a firm in the context of its short-term financial management? Why?
(b) A firm intends to use short term funding (e.g. short-term credit line) to finance its long-term assets. What are the advantages and disadvantages with such a policy?

Answer 1

(a)

If the carrying cost is high and shortage cost is low it implies that the firm is investing more on the inventory i.e current assets.

Carrying cost is the cost of carrying inventory i.e the warehousing cost, loss due to shrinkage or spoilage, insurance cost, etc.

Shortage cost occurs when a firm invests less in its current assets. It consists of ordering cost and cost of safety reserve.

In the given situation, carrying cost is high and the shortage cost is low. So in order to tackle the situation the firm should adopt restrictive policy.

In this policy, the estimation of current assets is done very aggressively without considering for any contingencies this policy is forcefully implemented in the organisation for that there is no deviation. Under this policy the investment in current assets is reduced lowest the working capital requirement which in turn produces more profitability that is higher return on investment.

The reason behind choosing restrictive policy is that the investment in current assets will reduce which will reduce the carrying cost of inventory and also in this policy no credit sales is allowed which ensures that the firm has sufficient cash balance to meet its needs i.e cost of placing order on time and ensuring safety reserve as well.

(b)

Using short term funding for long term assets comes under highly aggressive policy. Under this policy a part of fixed assets, permanent current assets and temporary current assets are financed through short term financing whereas only remaining part of fixed assets is financed through long term financing.

Advantages:

1. The financing cost is reduced because of low interest cost associated with it which increases the profitability.

2. Reduces carrying and handling cost of inventory as because short term funds are also used to finance current assets and fixed assets.

3. Increases efficiency in working capital management because of reduction in working capital.

Disadvantages:

1. The risk of insolvency is very high as because the financing is done from short term source which needs continuous renewal and refinancing which might not be easy all the time. And if in any unforeseen situation the refinancing is not done, company will have to sell its assets and can go into liquidation if unable to realise from those assets.

2. As short term sources are used to finance permanent current assets and fixed assets, there is shortage of short term funds and therefore there is no cushion for shock which can be caused due to shortage of raw material, machinery breakdown, etc.