Short Term Financial Policies

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PTMBA I / Trim III (A. Y. 2010-11) Div. C.

Assets of Short Term Financial Policy

Flexible Short Term Financial Policy

Maintainance of high ratio of current assets to sales. This would include:-

❖ Keeping large cash & bank balances
❖ Making substantial investment in inventories.
❖ Liberal Credit Term meaning high level of debtors.

Restrictive Short Term Financial Policy. This would include:-

❖ Low cash balances / no investment in marketable securities ❖ Small inventory level
❖ No credit on Sales & hence receivables at minimum

Thus, flexible short-term financial policies are costly in that they require higher cash outflows to finance cash and marketable securities, inventory, and accounts receivable. However, future cash inflows are highest with a flexible policy. Sales are stimulated by the use of a credit policy that provides liberal terms to customers. A large amount of inventory on hand ("on the shelf") provides a quick delivery service to customers and increases in sales. In addition, the firm can probably charge higher prices for the quick delivery service and the liberal credit terms of flexible policies. A flexible policy also may result in fewer production stoppages because of inventory shortages.

Managing current assets can be thought of as involving a trade-off between costs that rise with the level of investment (i.e. Carrying Cost) and costs that fall with the level of investment(i.e. Shortage Cost)

Carrying costs are generally of two types. First, because the rate of return on current assets is low compared with that of other assets, there is an opportunity cost. Second, there is the cost of maintaining the economic value of the item. For example, the cost of warehousing inventory belongs here.

Determinants of Corporate Liquid Asset Holdings

Firms with High Firms with Low
Holdings of LiquidHoldings of Liquid
Assets will HaveAssets will Have
High-growth opportunitiesLow-growth opportunities
High Risk InvestmentsLow-risk investments
Small FirmsLarge Firms
Low Credit firmsHigh Credit Firms

Firms will hold more liquid assets (i.e., cash and marketable securities) to ensure that they can continue investing when cash flow is low relative to positive NPV investment opportunities. Firms that have good access to capita1 markets will hold less liquid assets.

Shortage costs are incurred when the investment in current assets is low. If a firm runs out of cash, it will be forced to sell marketable securities. If a firm runs out of cash and cannot readily sell marketable securities, it may need to borrow or default on an obligation. (This general situation is called cash-out.,) If a firm has no inventory (a stockout) or if it cannot extend credit to its customers, it will lose customers.

Carrying Costs

Opportunity Maintaining
CostEconomic Value
(Rate of Return on (Cost of warehousing
Current assets is inventory)
Less compared to
Other assets)

There are two kinds of'shortage costs:

Shortages Costs

Trading or Order Cost Related to Safety reserves
Order costs are the costs of There are costs of lost placing an order for more sales, lost customer goodwill, cash (brokerage costs) or and disruption of production more inventory (production schedules. setup costs)



Flexible Policy



Restrictive Policy



Illustrates the basic nature of carrying costs. The total costs of investing in current assets are determined by adding the carrying costs and the shortage costs. The minimum point on the total cost curve (CA*) reflects the optimal balance of current assets. The curve is generally quite flat at the optimum, and it is difficult, if not impossible, to find the precise optimal balance of shortage...
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