One of the most important decisions to be made regarding the company's current assets and liabilities is how the current liabilities should be used to finance the current assets. There are several approaches to this financial decision
One of the determining factors that the company must take into account is that, for any company, only a limited amount of short-term financing is available.
The available amount of current liabilities is limited by purchases, in terms of current currency, in the case of accounts payable; for the amount in current currency of accumulated debts in the case of accumulated liabilities and for the amount of stationary loans that the lenders consider acceptable in the case of documents payable.
Lenders make short-term loans only to allow a business to finance the formation of its inventory or stationary accounts receivable; they never lend money in the short term for long-term uses.
Financing
Short-term loans are tailored to the actual need for funds
There are several approaches to determine an adequate financial capital structure. The three basic approaches or systems are:
- The compensatory approach The conservative approach The alternative between the two approaches
The compensatory approach
The compensatory approach requires the company to finance its short-term needs with short-term funds and long-term needs with long-term funds. Stationary variations in the company's funding requirements are met using short-term sources of funds, while permanent financial needs are met using long-term sources of funds.
The compensatory approach requires that the permanent part of the company's fund requirement be financed with long-term funds and the seasonal part be financed with short-term funds.
Cost considerations
- Cost of short-term funds: The cost of short-term funds can be estimated by calculating the average annual short-term loan and multiplying this sum by the annual interest rate applicable to short-term funds. Long-term cost of funds: The cost Long-term funding requirement can be calculated by multiplying the average annual long-term funding requirement by the annual interest rate applicable to long-term loans. Total cost of the compensatory program: The total cost of this program can be found by adding the cost of the funds short-term and long-term funds.
Risk considerations
The compensatory program operates without working capital since none of the company's short-term stationary needs is financed with the use of long-term funds.
The compensation plan is dangerous not only from the point of view of working capital but also because the company uses its short-term funding sources to the extent possible to cope with fluctuations in its funding requirements.
These aspects of risk related to the compensatory system result from the fact that a company has only limited short-term lending capacity and if it relies too much on this capacity it can become quite difficult to meet unforeseen needs for funds. This could have detrimental effects for the company.
The conservative approach
The most conservative approach would be to fund all projected fund requirements with long-term funds and use short-term funds in the event of an emergency or unexpected disbursement of funds.
It is hard to imagine how this system could actually be implemented, as certain short-term financial tools from the company are virtually unavoidable.
It would be quite difficult for a company to keep its accounts payable and accumulated liabilities low. Nor would accounts payable and accrued liabilities be thought to originate naturally from the process of doing business.
In companies, the lower the working capital, the higher the risk to obtain short-term financing.
Cost considerations
The effects of the conservative approach is the profitability of the company can be calculated by determining the cost of this financial plan; but in this approach the cost is very high since sometimes the company pays interest on money that it does not really need, that is, the period when it has working capital.
Risk considerations
The high level of working capital related to this approach means a very low level of risk for the company. The company's risk must also decrease because the program does not require the company to use its limited short-term loan capacity.
This means that if the total financing that the company requires really turns out to be at the level of the availability of obtaining short-term loans to cover unforeseen financial needs and avoid technical insolvency.
Alternatives between the two approaches
Most companies use a financial plan that falls somewhere between the compensatory approach of high profits versus high risk and the conservative approach of low profits versus low risk.
The exact alternative to be made between profitability and risk depends on the attitude towards risk that the decision maker takes. A selection of the exact point is vital for business development.
Cost considerations
The cost of the alternative plan can be calculated by establishing the necessary average funds in the short and long term, multiplying them by their respective interest rates also in the short and long term.
- Cost of short-term funds: The cost of short-term funds can be estimated by calculating the average short-term funds needed and multiplying them by the short-term interest rate. Long-term cost of funds: These are calculated by multiplying the Long-term average funding requirement by the annual long-term interest cost Total alternative program cost: The total cost of the alternative program is established by adding the cost of short-term funds and the cost of long-term funds.
Risk considerations
The alternative program is less risky than the compensatory approach, but more risky than the conservative one. What is really sought with this approach is to have a high probability of obtaining additional financing in the short term, since the short-term financial requirements are actually being financed with long-term funds.
In all cases, the financial manager must determine the financial plan that places the company at a point where the company's resources are not affected and short and long-term business objectives are not compromised.
