Question 4 (25 marks)
4.1 Discuss the THREE (3) Working Capital Financing policies ( 9marks)
4.2 Discuss the following sources of long-term financing for a business:
4.2.1 Ordinary and preference shares (10 marks)
4.2.2 Debentures (secured and unsecured) (7 mark)
4.1 Working Capital Financing Policies
Working capital financing policies determine how a company will finance its day-to-day operations and manage its short-term liabilities. There are three main working capital financing policies:
1. Conservative Policy: Under a conservative policy, a company maintains high levels of working capital to ensure liquidity and minimize the risk of running out of cash. This policy involves holding high levels of cash and inventory and maintaining a low level of short-term debt. While this policy reduces the risk of financial distress, it may also result in lower profitability due to the opportunity cost of holding excess working capital.
2. Aggressive Policy: In contrast, an aggressive working capital financing policy involves maintaining low levels of working capital to maximize profitability. This policy minimizes idle cash and inventory, allowing the company to invest surplus funds in high-return opportunities. However, an aggressive policy may expose the company to liquidity risks and increase the likelihood of financial distress if unexpected expenses arise.
3. Moderate Policy: A moderate or balanced working capital financing policy strikes a balance between the conservative and aggressive approaches. This policy aims to maintain an optimal level of working capital that allows the company to meet its short-term obligations while maximizing profitability and liquidity. Companies following a moderate policy carefully manage their working capital components to ensure efficient operations and financial stability.
Overall, the choice of a working capital financing policy depends on the company's risk tolerance, financial goals, and operating environment. Companies should regularly review and adjust their working capital policies to adapt to changing market conditions and optimize their financial performance.
4.2 Sources of Long-term Financing for a Business
4.2.1 Ordinary and Preference Shares
Ordinary and preference shares are common sources of long-term financing for businesses. Ordinary shares represent ownership in a company and give shareholders voting rights and the opportunity to receive dividends. Preference shares, on the other hand, have predetermined dividend payments and priority over ordinary shares in case of liquidation.
Advantages of ordinary and preference shares include:
- Equity financing does not require repayment of the principal amount and provides perpetual capital for the company.
- Shareholders bear the risk of the business, reducing the financial risk for the company.
- Companies can benefit from investors' expertise and connections, potentially leading to business growth opportunities.
However, there are also disadvantages to issuing shares:
- Dilution of ownership and control as new shareholders are added.
- Payment of dividends on preference shares is mandatory and reduces the company's cash flow.
4.2.2 Debentures (Secured and Unsecured)
Debentures are debt instruments issued by companies to raise long-term capital. They can be either secured or unsecured:
- Secured debentures are backed by specific assets of the company, providing security to the debenture holders in case of default.
- Unsecured debentures do not have specific assets as collateral, making them riskier for investors but potentially offering lower interest rates for the company.
Advantages of debentures include:
- Interest payments are tax-deductible, reducing the company's tax burden.
- Debentures have a fixed maturity date, allowing companies to plan their repayment obligations.
Disadvantages of debentures include:
- Companies have an obligation to pay interest even in years of financial difficulty.
- Issuing debentures increases the company's debt-to-equity ratio, potentially affecting credit ratings and borrowing costs.
In conclusion, both ordinary and preference shares, as well as debentures, are important sources of long-term financing for businesses. Companies should carefully evaluate their capital structure and financing options to balance risk and return in their financial decision-making.