Firms manage a variety of current assets. Permanent current assets are necessary
ID: 2614922 • Letter: F
Question
Firms manage a variety of current assets. Permanent current assets are necessary for firms to maintain their businesses, and they will be carried even through downturns in business cycles. Temporary current assets fluctuate seasonally or with business cycles. Firms must devise a financing strategy that best fits their business situation and that best manages their risk Use the following table to identify the different current asset financing policies. Description Financing Policy Long-term capital finances some permanent current assets, but short-term debt finances all temporary current assets and the remaining permanent current assets. Long-term capital finances all permanent current assets and some temporary financing needs. This current asset financing policy finances current assets with iabilities that are expected to mature at the same time the current asset will be liquidated. Why does the conservative approach tend to be less profitable than the other current asset financing policy approaches? O Short-term debt is usually cheaper than long-term debt. O Taking out long-term debt tends to be more profitable than taking out short-term debt. O All current asset financing approaches have the same potential profitability.Explanation / Answer
There are 3 approaches to Current Asset Financing.
Answer 1. AGGRESSIVE APPROACH
Under this approach, the firm finance not only its temporary current assets but also a part of permanent current assets with short-term sources of finance. This decision is totally based on trade-off between risk and return. In terms of cost, short-term capital is less costly but in terms of risk, long-term capital is less risky (for borrower).
Answer 2. CONSERVATIVE APPROACH
A firm follows conservative financing when it uses long term sources of capital to finance their current assets apart from financing the fixed assets. With long-term capital used, this approach is less risky in nature.
Answer 3. MATURITY MATCHING APPROACH
The nature of liabilities is matched with that of asset under this scheme. All permanent or fixed assets are financed by long term capital, whereas current assets are financed by current liabilities.
Answer to MCQ - "Short term debt is cheaper than long term debt"
As explained earlier short term debt is cheaper. In conservative policy, however, long-term debt is used for all financing purposes - current as well as fixed assets in conservative policy. Hence, this policy tends to be less profitable than other two strategies which also employ short term financing in their plans.
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