St.

Mary’s University
Faculty of Accounting and Finance
Department of Accounting and Finance
HEEE Summary Note
Note: This is a brief and comprehensive note aimed at preparing students for Higher
Education Exit Exam. It cannot be taken as a full length teaching material or module. The full
length teaching materials and modules are available on the St. Mary’s University’s LMS or
can be found upon the request of the course instructors.
Course Name Financial Management II
Thematic Area Corporate Finance
Instructor’s Name Wendmagegn Teshome
Course Description The course financial management II is a cocktail of various finance
concepts showering you with the knowledge, skills and attitudes of
capital structure, leverage, dividend policies, financial forecasting,
current assets management and current assets financing. This course is
organized as five chapters each of which contributes one question to
Higher Education Exit Exam according to the blue print for Higher
Education Exit Exam for Accounting and Finance.
Course Objectives After completing this course students will be able to:
 Define capital structure
 Determine the optimal capital structure according to various
theories.
 Comprehend the importance of leverage
 Differentiate financial and operating leverage.
 Be aware of the theories and policies of dividend.
 Forecast funds needed to expand businesses.
 Understand percent of sales method of forecasting
 Understand how to determine optimal cash and inventory
balance.
 Apply proper credit policy
 Manage and finance current assets
Course Contents
Chapter 1: Capital Structure Policy and Leverage

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 1.1. The capital structure question
1.2. Factors that influence capital structure decisions
1.3. Business and Financial Risk
1.3.1. Business risk and operating leverage
1.3.2. Financial risk and financial leverage
1.4. Determining the optimal capital structure
1.4.1. EBIT/EPS analysis
1.4.2. The effect of capital structure on stock price and the cost
of capital
1.5. Introduction to the theory of capital structure
1.5.1. Modigliani and Miller (M&M) Propositions I and II
with no taxes
1.5.2. Modigliani and Miller (M&M) Propositions I and II
with taxes
1.5.3. Trade-off theory (Static Trade-off Hypothesis)
1.5.4. Signaling theory
1.5.5. Using debt financing to constrain managers
Chapter 2: A Review of Dividends and Dividends Policy
2.1 Dividend theories
2.2 Establishing the dividend policy in practice
2.3 Factors influencing dividend policy
2.4 Other factors related to cash dividends:
2.4.1 Stock dividends and stock splits
2.4.2 Stock repurchases
Chapter 3: Financial Forecasting
3.1 Overview of financial forecasting
3.2 Forecasting growth rates and outside financing
3.3 Forecasting external financing needs
3.4 Financial statement forecasting: the percentage of sales method
Chapter 4: Managing Current Asset
4.1 Working capital terminologies
4.2 Alternative current asset investment policies
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 4.3 Cash management
4.4 Managing inventory
4.5 Receivables management
Chapter 5: Financing Current Assets
5.1 Alternative current asset financing policies
5.2 Advantage and disadvantage of short-term financing
5.3 Sources of short-term financing
Chapter one
Capital Structure Policy and Leverage
Objectives After completing this chapter, students should be able to:
 Explain capital structure theories
 Value firms using capital structure theories
 Compute operating, financial and total leverages
 Conduct EBIT-EPS to support business decisions
1. Comprehensive Notes
1.1. Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that makeup
capitalization. The term capital structure refers to the relationship between the various long-
term sources of financing such as equity capital, preference share capital and debt capital.
Deciding the suitable capital structure is the important decision of the financial management
because it is closely related to the value of the firm. Capital structure is the permanent
financing of the company represented primarily by long-term debt and equity.
1.2. Factors that Influence Capital Structure Decision
Four primary factors influence capital structure decisions.
6 Business risk
7 The firm’s tax position.
8 Financial flexibility
9 Managerial conservatism or aggressiveness:
1.3. Business and Financial Risk
1.3.1. Business Risk and Operating Leverage
Business risk is the possibility of a commercial business making inadequate profits due to
uncertainties. Factors affecting Business risk include:

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  Demand variability. The more stable the demand for a firm’s products, the lower its
business risk.
 Sales price variability. Firms whose products are sold in highly volatile markets are
exposed to more business risk than similar firms whose output prices are more stable.
 Input cost variability. Firms whose input costs are highly uncertain are exposed to a
high degree of business risk.
 Ability to adjust output prices for changes in input costs. The greater the ability to
adjust output prices to reflect cost conditions, the lower the degree of business risk.
 Ability to develop new products in a timely, cost-effective manner. Firms in such high-
tech industries as drugs and computers depend on a constant stream of new products.
The faster a firm’s products become obsolete, the greater its business risk.
 Foreign risk exposure. Firms that generate a high percentage of their earnings overseas
are subject to earnings declines due to exchange rate fluctuations. .
 The extent to which costs are fixed: operating leverage. If a high percentage of costs
are fixed, then the firm is exposed to a relatively high degree of business risk.
Operating leverage is concerned with the relationship between the firm’s sales revenue and its
earnings before interest and taxes (EBIT) or operating profits. It is the use of fixed operating
costs to magnify the effects of changes in sales on the firm’s earnings before interest and
taxes. The degree of operating leverage (DOL) is the numerical measure of the firm’s
operating leverage.
PercentageChangeinEBIT Sales−Variable Cost
DOL= OR DOL=
PercentageChangeinSales sales−Variable Cost−¿ Cost
As long as DOL is greater than 1, there is operating leverage
1.3.2. Financial Risk and Financial Leverage
Financial risk is the type of danger that can result in the loss of capital to interested parties.
Financial leverage is the use of fixed financial costs to magnify the effects of changes in
earnings before interest and taxes on the firm’s earnings per share. The two most common
fixed financial costs are (1) interest on debt and (2) preferred stock dividends.
The degree of financial leverage (DFL) is the numerical measure of the firm’s financial
leverage.

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 PercentageChangeinEPS EBIT
DFL= ∨DFL=
PercentageChangeinEBIT EBIT −I −¿ ¿

Whenever DFL is greater than 1, there is financial leverage.

Total Leverage
We also can assess the combined effect of operating and financial leverage on the firm’s risk
by using a framework similar to that used to develop the individual concepts of leverage. This
combined effect, or total leverage, can be defined as the potential use of fixed costs, both
operating and financial, to magnify the effect of changes in sales on the firm’s earnings per
share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s
operating and financial structure.
PercentageChangeinEPS
DTL=
PercentageChangeinSales
DTL=DOL X DFL
1.4. Determining the Optimal Capital Structure
What, then, is an optimal capital structure, even if it exists (so far) only in theory? Generally
speaking the optimal capital structure is considered to be that which minimizes the weighted
average cost of capital, WACC, and consequently maximizes the value of the firm. It is
generally believed that the value of the firm is maximized when the cost of capital is
minimized. By using a modification of the simple zero-growth valuation model, we can define
the value of the firm, V,

NOPAT EBIT −Tax

V=
WACC
= V= WACC

1.4.1. EBIT‐EPS Analysis

EBIT‐EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT‐EPS analysis may be defined as ‘a tool of
financial planning that evaluates various alternatives of financing a project under varying
levels of EBIT and suggests the best alternative having highest EPS and determines the most
profitable level of EBIT’.
Various advantages derived from EBIT‐EPS analysis may be enumerated below:

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  Financial Planning
 Comparative Analysis
 Performance Evaluation
 Determining Optimum Mix
1.5. The Effect of Capital Structure on Stock Price and Cost of Capital
According to Modigliani and Miller, a firm’s cost of capital is said to be independent of its
capital structure under the assumption of a perfect market which only exists in theory.
A study in Kenya found that there is positive relationship between capital structure and the
cost of capital such that an increase in capital structure resulted in an increase in the cost of
capital. The study concluded that an increase in the leverage ratio will lead to an increase in
the cost of capital, while a decrease in leverage will correspond to a decrease in the cost of
capital of firm.
In another study in Kenya gearing ratio and debt were found to positively affecting share
prices, while equity negatively affected share prices.
1.6. Introduction to the Theory of Capital Structure
1.6.1. Modigliani and Miller (MM) Theory
[Link]. MM Theory with No Corporate Taxes
M&M proposed that the value of a firm is independent of its cost of capital and its capital
structure.
MM’s study was based on some strong assumptions:
 There are no brokerage costs.
 There are no taxes.
 There are no bankruptcy costs.
 Investors can borrow at the same rate as corporations.
 All investors have the same information as management about the firm’s future
investment opportunities.
 EBIT is not affected by the use of debt.
Proposition I (Capital Structure Irrelevance Proposition)
 Value of the firm is unaffected by capital structure; therefore, the capital structure is
irrelevant.
 The value of the firm depends on its cash flow and riskiness of the assets.

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Value unlevered firm = Vu = Value of levered firm = VL= EBIT/WACCand
Share price of unlevered firm = Share price of levered firm (By implication)
Proposition II (Cost of Equity and Leverage Proposition)
 Cost of equity increases linearly as firm increases its proposition of debt financing,
leaving its weighted average cost of capital unchanged.
WACC = Ka = Ke (E/(D+E)) + Kd (D/(E+D))
Ke = Ka + (Ka - Kd)D/E (By implication)
(Ka - Kd)D/E = Financial Risk Premium
When D = 0, Ke = Ka
Where,
Ke = Cost of equity
Ka = Return on assets =Weighted average cost of capital
Kd = Cost of debt
D = Market value of debt
E = Market value of equity
[Link]. MM Theory with Corporate Taxes
Proposition I
 When there are corporate taxes, interest becomes tax deductable and this increases the
firms cash flow; therefore, the value of levered firm becomes greater than the value of
unlevered firm.
 The value levered firm is the sum of the value unlevered firm and the present value of
interest tax shield
VL = VU + Tc X D
Where,
Tc = Corporate tax rate
D = The value of debt of the levered firm
Proposition II
 The cost of equity increases as financial leverage increases
 With increase in financial leverage, WACC decreases.
1.6.2. Trade-off Theory
The tradeoff theory of leverage argues that firms trade off the benefits of debt financing

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(favorable corporate tax treatment) against the higher interest rates and bankruptcy costs. The
fact that interest is a deductible expense makes debt less expensive than common or preferred
stock. In effect, the government pays part of the cost of debt capital, or, to put it another way,
debt provides tax shelter benefits. As a result, using debt causes more of the firm’s operating
income (EBIT) to flow through to investors. Therefore, the more debt a company uses, the
higher its value and stock price. At low leverage levels, tax benefits outweigh bankruptcy costs.,
and at high levels, bankruptcy costs outweigh tax benefits.
VL = VU + PV tax shied – Financial distress costs
1.6.3. Signaling Theory
Managers use issues of debt and equity to signal information about a firm’s future prospects to
less informed owners and investors. Issuing debt would be interpreted as a positive signal
about the company’s future. In contrast, the decision to issue equity would generally be
interpreted by shareholders and investors as a negative signal.
1.6.4. The Pecking Order Theory
This theory states that companies prefer to finance with retained earnings. They do not resort
to external sources but to internal ones because they have less financial risk. The latter are
chosen only when there is a reduction in the cost of capital.
1.6.5. The Theory of Market Timing
This theory states that the company issues shares when it perceives that its shares are
overvalued and repurchases them when it discovers that they are undervalued. It has two
versions. According to the first version, agents must be rational; for this reason, the shares can
be issued directly to the investor. According to the second version, however, it is claimed that
the information is incorrect. Agents think they have complete information on time to market.
Transfer time is a key point in timing it.
1.7. Using Debt Financing to Constrain Managers
Agency problems may arise if managers and shareholders have different objectives. Such
conflicts are particularly likely when the firm's managers have too much cash at their disposal.
Managers often use excess cash to finance pet projects or for perquisites such as nicer offices,
corporate jets, and sky boxes at sports arenas, all of which may do little to maximize stock
prices. Managers with limited "excess cash flow" are less able to make wasteful expenditures.
Firms can reduce excess cash flow in a variety of ways. One way is to funnel some of it back

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to shareholders through higher dividends or stock repurchases. Another alternative is to shift
the capital structure toward more debt in the hope that higher debt service requirements will
force managers to be more disciplined. If debt is not serviced as required, the firm will be
forced into bankruptcy, in which case its managers would likely lose their jobs.

Model Questions
1. Suppose there are two firms, U and L. Firm U is the Unlevered Firm and Firm L is the
Levered Firm. Firm U has 10,000 shares @ br. 12 per share. Firm L has 5,000 shares
@ br. 12 per share and 6% bond worth br. 60,000. Operating income of both the firms
is br. 18,000. Using MM theory, answer the following assuming no corporate taxes,
and 30% tax rate respectively.
A) What are the values of Firm U and Firm L?
B) What are the costs of equity of Firm U and Firm L?
2. A Ltd. Has a share capital of br.300,000 divided into share of br.10 each. It has a major
expansion program requiring an investment of another br.100,000. The Management is
considering the following alternatives for raising this amount:
a. Issue of 10,000 equity shares of br.10 each
b. Issue of 10,000, 12% preference shares of br.10 each
c. Issue of 10% debentures of br.100,000
d. Issue of 4,000 equity shares of br.10 each, issue of 4,000, 12% preference shares of br.
10 each and issue of 10% debentures of br.20,000
The company’s present Earnings before Interest and Tax (EBIT) are br. 75,000 per annum
subject to tax @ 40%. You are required to calculate the effect of the above financial plan on
the earnings per share presuming:
A) EBIT continues to be the same even after expansion
B) EBIT increases by br. 5,000
3. Bob and Jim are both looking to purchase the same house that costs $500,000. Bob
plans to make a 10% down payment and take a $450,000 mortgage for the rest of the
payment (mortgage cost is 7% annually). Jim wants to purchase the house for $500,000
cash today.
A. Who will realize a higher return on investment if they sell the house for $550,000 a

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 year from today?
B. Who will see a greater loss on their investment if they can only sell the house for
$400,000 after a year?
4. XYZ Company has an EBIT of $2,000,[Link] interest liability is $200,000. The
company has issued 10% preference shares of $500,000 and 50,000 equity shares of
$100 each. The average tax applicable to the company is 30% and corporate dividend
tax is 20%.Calculate the degree of financial leverage.
Chapter two A Review of Dividends and Dividend Policy
objectives After Completing this chapter Students should be able to:
 Define dividend and dividend policy
 Explain irrelevance and relevance theories of dividend
 Compute dividend paid using dividend theories
2. Comprehensive Notes
2.1. The Meaning of Dividend
Dividend refers to that portion of profit which is distributed among the owners or shareholders
of the firm. The finance manager has to take few decisions which are inter–related like
investment, financing and dividend decisions.
2.2. Types of Dividend
Dividends are classified into:
Cash Dividend: If the dividend is paid in the form of cash to the shareholders, it is called cash
dividend. Cash dividends are common and popular types followed by majority of the business
concerns.
Stock Dividend: Stock dividend is paid in the form of the company stock. Stock dividend may
be bonus issue. This issue is given only to the existing shareholders of the business concern.
Bond Dividend: Bond dividend is also known as script dividend. If the company does not
have sufficient funds to pay cash dividend, the company promises to pay the shareholder at a
future specific date with the help of issue of bond or notes.
Property Dividend: Property dividends are paid in the form of some assets other than cash. It
will be distributed under the exceptional circumstance.
2.3. Dividend Policy
A dividend policy can be defined as the dividend distribution guidelines provided by the board

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 of directors of a company. It sets the parameter for delivering returns to the equity
shareholders, on the capital invested by them in the business. While taking such decisions, the
company has to maintain a proper balance between its debt and equity composition.
2.3.1. Types of Dividend Policy
No Dividend Policy: Here, the company always retains the profits to fund further projects.
Moreover, it has no intention of declaring any dividends to its shareholders. This strategy may
seem to be beneficial for business growth but usually discourages the investors aiming for
sustainable income.
Stable Dividend Policy: In this policy, the company decides a fixed amount of dividend for
the shareholders, which is paid periodically. There is no change in the dividend allowed even
if the company incurs loss or generates high profit.
Regular Dividend Policy: Here, a certain percentage of the company’s profit is allowed as
dividends to the shareholders. When the gain is high, the shareholders’ earnings will also hike
and vice-versa. It is one of the most appropriate policies to be adopted for creating goodwill.
Irregular Dividend Policy: Under this changeable policy, the company may or may not pay
dividends to the shareholders. The top management i.e., the board of directors solely take all
dividend decisions, as per their priorities.
2.3.2. Theories of Dividend Policy
[Link]. Irrelevance Theories
A. Residual Theory: According to this theory, dividend policy has no effect on the wealth of
the shareholders or prices of the shares and hence it is irrelevant so far as the valuation of the
firm is concerned. This theory regards dividend policy merely as a part of financial decision
because the earnings available may be retained in the business for reinvestment. But if the
funds are not required in the business they may be distributed as dividend. Thus, the decision
to pay dividends or retain the earnings may be taken as residual decision.
Residual Dividend Model
Dividends = Net Income – (Target Equity Ratio x Total Capital Budget)
B. Modigliani and Miller Approach: Modigliani and Miller have argued that firm’s dividend
policy is irrelevant to the value of the firm. According to this approach, the market price of
shares is dependent on the earnings of the firm on its investment and not on the dividend paid
by it. Earnings of the firm which affect its value, further depends upon the investment

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 opportunities available to it.

Assumptions
 Perfect Capital Markets
 No Taxes
 Fixed Investment Policy
 No Risk of Uncertainty
 Investor is indifferent between dividend income and capital gain income
Formula of Modigliani and Miller Approach
D 1+ P1
P 0=
1+ K
( n+Cn ) P1−I + E
V or n P 0=
1+ K
P0= Current market price of the share.
K= Cost of equity capital.
D1= Expected dividend at the end of the year.
P1= Expected price of the share at the end of year one.
n = Number of shares at the beginning of the period
Cn = Number of shares issued to raise the funds required
V = Value of the firm
E = Earnings during the period (EAT)
[Link]. Relevance Theories
A. Walter’s Model: According to Walter’s Model, value of the firm depends upon firm’s
earning level, dividend payout, constant reinvestment rate and the shareholder’s expected rate
of return. The model suggests that dividend policy of the company depends upon the fact that
whether firm has got good investment opportunities or not. If the firm does not have enough
investment opportunities then it will pay the dividend otherwise it will retain the money.
Company IRR vs Ke Correlation Optimal

b/n Dividend

Firm Value & Dividend Payout Ratio

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 Growth IRR > Ke Negative 0

Constant IRR = Ke No Correlation Any

Decline IRR < Ke Positive 100%

Formula of Walter’s Model

P 0=
D+ ( Ker )(E−D)
Ke
P = Market price of equity share.
D = Dividend per share.
E = Earnings per share.
r = Rate of return on investment of the firm.
Ke= Cost of equity share capital.
Hence, Value of firm = N × P
Where, N = No. of outstanding equity shares.
B. Gordon’s Model: According to Gordon’s Model, Dividend policy of a firm is relevant and
can affect the value of a firm. Value of the firm under this method depends upon reinvestment
rate (r) and shareholder’s expectations (K). This is based on the premise that the investors are
generally risk averse and prefer to have current income i.e. dividend. Hence there is a direct
relationship between dividend policy and the value of a firm.
Assumption
 No Debt
 No External Financing
 Constant Internal Rate of Return
 Constant Cost of Capital
 Perpetual Earnings
 Corporate taxes
 Constant Retention Ratio
 K>g
Formula of Gordon’s Model

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 E(1−b)
P=
K −br
P = Market price of equity share.
E = Earnings per share.
b = Retention ratio.( 1 – payout ratio)
r = Rate of return on investment.
K= Cost of equity capital.
br = Growth rate of the firm.
Hence, value of firm = N × P
Where, N = No. of outstanding equity shares.
D. Tax Preference Theory
There are three tax-related reasons for thinking that investors might prefer a low dividend
payout to a high payout: (1) Long-term capital gains are taxed at a lower rate than dividend
income. (2) Taxes are not paid on the gain until a stock is sold. Due to time value effects, a
dollar of taxes paid in the future has a lower effective cost than a dollar paid today. (3) If a
stock is held by someone until he or she dies, no capital gains tax is due at all—the
beneficiaries who receive the stock can use the stock’s value on the death day as their cost
basis and thus completely escape the capital gains tax. Because of these tax advantages,
investors may prefer to have companies retain most of their earnings.
2.4. Factors Influencing Dividend Policy
The factors may be grouped into four broad categories:
A. CONSTRAINTS
1. Bond indentures. Debt contracts often limit dividend payments to earnings generated after
the loan was granted.
2. Preferred stock restrictions. Typically, common dividends cannot be paid if the company
has omitted its preferred dividend.
3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet item
“retained earnings.” It is designed to protect creditors.
4. Availability of cash. A shortage of cash in the bank can restrict dividend payments.
However, the ability to borrow can offset this factor.
5. Penalty tax on improperly accumulated earnings. To prevent wealthy individuals from

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 using corporations to avoid personal taxes, the Tax Code provides for a special surtax on
improperly accumulated income.
B. INVESTMENT OPPORTUNITIES
1. Number of profitable investment opportunities. If a firm typically has a large number of
profitable investment opportunities, this will tend to produce a low target payout ratio.
2. Possibility of accelerating or delaying projects. This permits a firm to adhere more
closely to a stable dividend policy.
C. ALTERNATIVE SOURCES OF CAPITAL
1. Cost of selling new stock. A high dividend payout ratio is more feasible for a firm whose
flotation costs are low. The flotation percentage is generally higher for small firms, so they
tend to set low payout ratios.
2. Ability to substitute debt for equity. Low stock flotation costs permit a more flexible
dividend policy because equity can be raised either by retaining earnings or by selling new
stock. A similar situation holds for debt policy: If the firm can adjust its debt ratio without
raising costs sharply, it can pay the expected dividend, even if earnings fluctuate, by
increasing its debt ratio.
3. Control. If management is concerned about maintaining control, it may be reluctant to sell
new stocks, hence the company may retain more earnings than it otherwise would. However, if
stockholders want higher dividends and a proxy fight looms, then the dividend will be
increased.
D. EFFECTS OF DIVIDEND POLICY ON Cost of Capital (Ks)
The effects of dividend policy on ks may be considered in terms of four factors:
(1) Stockholders’ desire for current versus future income,
(2) Perceived riskiness of dividends versus capital gains,
(3) The tax advantage of capital gains over dividends, and
(4) The information content of dividends (signaling).
2.5. Stock Splits
Stock splits can be of any size—for example, the stock could be split two-for-one, three-for-
one, one-and-a-half-for-one, or in any other way. Each stock holder would have more shares,
but each share would be worth less.
2.6. Stock Repurchases

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 There are three principal types of repurchases:
(1) Situations where the firm has cash available for distribution to its stockholders, and it
distributes this cash by repurchasing shares rather than by paying cash dividends;
(2) Situations where the firm concludes that its capital structure is too heavily weighted with
equity, and then it sells debt and uses the proceeds to buy back its stock; and
(3) Situations where a firm has issued options to employees and then uses open market
repurchases to obtain stock for use when the options are exercised.
Stock that has been repurchased by a firm is called treasury stock. If some of the outstanding
stock is repurchased, fewer shares will remain outstanding. Assuming that the repurchase does
not adversely affect the firm’s future earnings, the earnings per share on the remaining shares
will increase, resulting in a higher market price per share. As a result, capital gains will have
been substituted for dividends.

Model Questions
I. Consider a business with a capital budget of $8,000,000. The business follows a 60-40
debt-equity split that they wish to maintain. The company makes a net income forecast
of $5,000,000. What is the forecasted residual dividend payment by the firm?
II. Wawa Ltd. Currently has 100,000 equity shares outstanding. Current market price per
share is br. 40. The net income for the current year is br. 200,000 and investment
budget is br.500,000. Cost of equity is 10%. The company is contemplating declaration
of dividends @ br. 8 per share. Assuming MM approach:
i. Calculate the expected market price per share after one year if dividend
is declared and if it is not declared.
ii. How many equity shares are to be issued under both the options?
III. Assuming that cost of equity is 11%; rate of return on investment is 12%; and earnings
per share is br.15. Calculate price per share by Gordon Model assuming dividend
payout ratios of 10% and 20%.
Chapter Three Financial Forecasting
objectives After completing this chapter, students should be able to:
 Define the importance of financial forecasting
 Forecast growth amounts and growth rates

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  Explain percentage of sales method
3. Comprehensive Notes
3.1. Overview of Financial Forecasting
Financial forecasting is a planning process by which the company’s management positions its
firm’s future activities related to the expected economic, technical, competitive and social
environment. Business plans always have strategies and actions for achieving desired short-
term, intermediate, and long –term results. These are qualified in financial terms, in the form
of projected Financial Statements (pro forma statements) and a variety of operational budgets.
Financial decisions are based on forecasts of situations a business expects to confront in the
future. Businesses develop new products, set production quotas, and select financing sources
based on forecasts about the future economic environment and the firm’s condition. If
economists predict interest rates will increase, for example, a firm may borrow now to lock in
today’s rates. Forecasting in business is especially important because failing to anticipate
future trends can be devastating.
3.2. Forecasting Growth Rates
Understanding and accurately predicting growth rates is essential for businesses to make
informed decisions and strategize effectively. By analyzing historical data and considering
various perspectives, we can gain valuable insights into growth patterns and identify areas for
improvement.
Insights from Different Point of Views:
a. Historical Analysis: To forecast growth rates, it is essential to analyze past
performance. By examining historical data, such as revenue, customer
acquisition, or market trends, businesses can identify patterns and trends that
can inform future projections.
b. Market research: Conducting thorough market research allows businesses to
understand industry dynamics, customer behavior, and competitive landscape.
This information helps in assessing market potential and estimating growth
rates based on market demand and competition.
c. Internal Factors: Internal factors, such as product development, marketing
strategies, and operational efficiency, play a significant role in growth rate
forecasting. By evaluating these factors, businesses can identify strengths and

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 weaknesses that impact growth potential.
d. External Factors: External factors, including economic conditions, regulatory
changes, and technological advancements, can influence growth rates.
Considering these factors helps in understanding the broader context and
anticipating potential challenges or opportunities.
 At its core, growth rate measures the percentage change in a particular quantity over a
specific period. It's a fundamental concept in fields like finance, economics, and
biology.
 Imagine you're tracking the number of subscribers to your newsletter. If you had 100
subscribers last month and now have 120, your growth rate is (120-100)/100 = 20%
 Growth rates can be positive (indicating expansion) or negative (indicating
contraction).
Forecasting Methods:
A. Regression
Regression equations attempt to explain the behaviour of a selected dependent variable by the
behaviour of one or more independent (or explanatory) variables. For example, the behaviour
of sales (units) of a particular brand of car may be dependent on four explanatory variables –
personal income, the price and advertising expenditure of that brand and the price of its closest
substitute brand.
In order to forecast the future values using an estimated regression equation, it is first
necessary to identify the variables which explain the historical behaviour of the dependent
variable. If the historical values for the relevant variables can be collected, an appropriate
regression equation can be estimated using, for example, the ordinary least squares (OLS)
technique.
When the dependent variable being forecast is largely influenced by a single explanatory
variable, the two-variable regression model – one explanatory variable explaining the
behaviour of the dependent variable – is used. When the variable being forecast is influenced
by two or more explanatory variables, the multiple regression model – two or more variables
explaining the behaviour of the dependent variable – is used.
B. Forecasting with time-trend projections
One basic requirement when using regression analysis for forecasting is the availability of

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 predictions for the explanatory variable or variables. When predictions are not available and
when the time series exhibits a long-term trend, time-trend projections can be used for
forecasting. Time-trend projections are flexible and may be used both for short-term or long-
term forecasts. Time-trend forecasts are particularly suitable for time series which exhibit a
consistent increase or decrease over time and where the past pattern is expected to continue in
the future. The time-trend method may be viewed as a special case of simple regression
analysis where the independent variable is ‘time’.
C. Forecasting using smoothing models
The earlier discussion of regression and time-trend models applies to situations where the
historical time series exhibits a trend. However, there are situations where the historical time
series does not exhibit a significant trend. In such cases, smoothing models can be used for
forecasting because these models adapt well to changes in the level of the time series. These
models are particularly suitable for situations where the more recent observations are more
indicative of future values. This is because these techniques can assign greater weight to the
most recent observations of the time series in making forecasts. In some smoothing models,
such as ‘simple moving average’, the average of the last three or four observations is used as
the forecast for the next period. This may result in loss of information. However, if the
historical data series does not exhibit a trend and if the decision-makers believe that only the
most recent data are relevant, the loss of information pertaining to past periods, which are
many years before the current period, is irrelevant.
Smoothing models are easy to use and generally provide reasonable forecasts for the short- to
medium-term forecasting periods, for example, the next two to three years. A disadvantage of
smoothing models is that they will not catch turning points since the basis of the forecast is
nothing but a weighted average of the historical data. Smoothing models are also not suitable
for a project concerned with a new product, as the moving averages are based on historical
data for an existing product.
The two simplest smoothing-based forecasting methods are simple moving average and
weighted moving average.
The simple moving average (SMA) uses the average of the “n” most recent values in the time
series as the forecast for the next period.
In SMA, each observation in the calculation receives equal weight. For example, in the three-

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 year SMA example, all three selected observations have equal weights of one-third. In the
weighted moving average (WMA), different weights are assigned to the values in the time
series. For example, if the decision-maker believes that recent values are more important than
less recent ones in arriving at forecasts, greater weight can be given to these. The weights must
add up to 1.

3.3. Forecasting External Financing Needs

Here are a firm’s primary capital sources:
a. Spontaneous Increases in Accounts Payable and Accruals. A firm has to
make additional purchases to increase its inventories, and it must hire more
workers to increase sales. Its purchases will automatically lead to additional
accounts payable. Also, hiring more workers will automatically lead to higher
accrued wages.
b. Addition to Retained Earnings. Assuming a firm has positive earnings and
does not pay out all of those earnings as dividends its retained earnings will
grow.
c. AFN: Additional Funds Needed. It is possible that spontaneous funds and
additional retained earnings will offset the forecasted increase in assets.
Normally, though, that situation does not occur—normally, there is a shortfall,
called additional funds needed (AFN), which has to be made up by additional
borrowing and/or the sale of new stock.
Note, though, that if a company is growing very slowly and thus not increasing assets very
much, its spontaneous funds plus its addition to retained earnings may be larger than the
required increase in assets. In that case, the AFN is negative, indicating that a surplus of
capital is forecasted.
AFN = Projected increase in assets - Spontaneous increase in liabilities - increase in
retained earnings
AFN= CS (∑ RA – ∑ RL)/S0 - mbs1
Where: m= profit margin
b = Retention rate

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 S1 = Forecasted sales
S0 = Previous Year Sales
CS = Change in Sales
RA = Responsive Assets
RL = Responsive Liabilities

While firms are interested in growth, they may be reluctant to raise external equity capital for
the following reasons: (i) there might be significant degree of under pricing when external
equity is raised. (ii) The cost of issue tends to be unreasonably high. (iii) The dilution of
control, consequent to the external issue, may not be acceptable to the existing controlling
interest. Given managerial disinclination to raise external equity capital, the following
question is often raised in corporate financial planning: What rate of growth can be sustained
with internally available equity?
The sustainable growth rate = Return on equity X Retention ratio
3.4. Financial Statement Forecasting: The Percentage of Sales Method
Percentage of sales is the most widely used method for projecting the company's financing
needs. This method involves estimating the various expenses, assets, and liabilities for a future
period as a percent of the sales forecast and then using these percentages, together with the
projected sales, to construct pro forma balance sheets. Normally, the last pro forma statement
prepared is the balance sheet. All other elements of the budget process must be completed
before it can be developed.
The basic steps in projecting financing needs are:
o Project the firm's sales. The sales forecast is the initial most important step.
Most other forecasts (budgets) follow the sales forecast.
o Project additional variables such as expenses.
o Estimate the level of investment in current and fixed assets required to support
the projected sales.
o Calculate the firm's financing needs.
o Establish a system of control

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 Model Questions
1. The following information is available for Astra Infotech Limited:
Net profit margin: 20%
Asset turnover: 1.2
Equity multiplier: 1.1
Dividend payout ratio: 0.25
What is the sustainable growth rate for Astra Infotech Limited?
2. Assume a company's sales are projected to grow from br. 2 million in 2020 to br. 2.1
million in 2021. Applying percentage of sales method, what could be its cost of goods sold for
the year 2021 if the company’s cost of goods sold was br. 1.5 million in 2020?
3. Pierce Furnishings generated $2.0 million in sales during 2020, and its year-end total assets
were $1.5 million. Also, at year-end 2020, current liabilities were $500,000, consisting of
$200,000 of notes payable, $200,000 of accounts payable, and $100,000 of accrued liabilities.
Looking ahead to 2021, the company estimates that its assets must increase by 75 cents for
every $1 increase in sales. Pierce’s profit margin is 5 percent, and its retention ratio is 40
percent. How large a sales increase can the company achieve without having to raise funds
externally?
4. Edwards Industries has $320 million in sales. The company expects that its sales will
increase 12 percent this year. Edwards’s CFO uses a simple linear regression to forecast the
company’s receivables level for a given level of projected sales. On the basis of recent history,
the estimated relationship between receivables and sales (in millions of dollars) is:
Receivables = $9.25 + 0.07(Sales)
Given the estimated sales forecast and the estimated relationship between receivables and
sales, what are your forecasts of the company’s year-end balance for receivables and its year-
end receivable turnover and days of sales outstanding (DSO) ratio? Assume that DSO is
calculated on the basis of a 365-day year.
5. Based on the data from the following table choosing n = 3, three-year moving averagesusing
the simple moving average (SMA) forecasting, what is the expected unit of sales for year 6
and year 7?
Year Sales Units

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 1 39,000

2 30,000

3 41,000

4 50,000

5 45,000

Chapter Four Managing Current Assets

Objectives After completing this chapter students should be able to:
 Define working capital terminologies
 Understand alternative current asset investment policies
 Explain the management of cash, inventories and receivables
4. Comprehensive Notes
4.1. Working Capital Terminologies
1. Working capital (Gross working capital): refers to current assets used in operations.
2. Net working capital: is defined as current assets minus current liabilities.
3. Net operating working capital: is defined as current assets minus noninterest-bearing
current liabilities. More specifically, net operating working capital is often expressed as cash
and marketable securities, accounts receivable, and inventories less accounts payable and
accruals.
4. The current ratio: It is calculated by dividing current assets by current liabilities.
5. Quick ratio or acid test ratio: It is calculated by deducting inventories from current assets
and then dividing the remainder by current liabilities.
6. Working capital policy: Working capital policy involves two basic questions: (1) What is
the appropriate amount of current assets for the firm to carry, both in total and for each
specific account (cash, accounts receivable, marketable securities, inventory and prepaid
expenses), and (2) how should current assets be financed?
8. Working capital management: involves both setting working capital policy and carrying
out that policy in day-to-day operations.
4.2. Alternative Current asset Investment Policies

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 There are three alternative policies regarding the total amount of current assets carried.
A. Relaxed current asset investment (fat cat) policy: Where relatively large amounts of
cash, marketable securities, and inventories are carried and where sales are stimulated by the
use of a credit policy that provides liberal financing to customers and a corresponding high
level of receivables.
B. Restricted current asset investment (lean and mean) Policy: With this policy, the
holdings of cash, securities, inventories, and receivables are minimized.
C. Moderate current asset investment policy: The moderate current asset investment policy
is between the two extremes. Under conditions of certainty- when sales, costs, lead times,
payment periods are known for sure- all firms would hold only minimal levels of current
assets. Any larger amounts would increase the need for working capital financing without a
corresponding increase in profits, while any smaller holdings would involve late payments to
labor and suppliers and lost sales due to inventory shortages and an overly restrictive credit
policy.
4.3. Cash Management
4.3.1. Motives for holding cash and near cash balances
There are three motives for holding cash and near cash (marketable securities) balances.
A) Transaction motive: A firm maintains cash balances to make planned payments for items
such as materials and wages.
B) Safety motive: To protect the firm against being unable to satisfy unexpected demands for
cash.
C) Speculative motive: This is a motive of holding cash or near cash to put unneeded funds to
work or to be able to quickly take advantage of unexpected opportunities that may arise.
Speculative motive is the least common of the three motives.
4.3.2. How Much Should a Firm Keep on Hand?
Managers must keep enough cash to make payments when needed (Minimum balance). But
since cash is a non-earning asset, managers should invest excess returns and keep just the
amount of cash that is necessary (Maximum balance)
The size of the minimum cash balance depends on:
 How quickly and cheaply a firm can raise cash when needed.
 How accurately managers can predict cash requirements.

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  How much precautionary cash the managers need for emergencies.
The firm’s maximum cash balance depends on:
 Available (short-term) investment opportunities
e.g. money market funds, CDs, commercial paper
 Expected return on investment opportunities (opportunity cost)
If high expected return, firms are quick to invest excess cash
 Transaction cost of withdrawing cash and making an investment

4.3.3. Choosing the Optimum Cash Balance

There are two models which can be used to calculate the optimum b alance of cash to be
maintained. They are Optimum Cash Balance under Certainty: Baumol’s Model and
Optimum Cash Balance under Uncertainty: The Miller–Orr Model
Baumol Model Assumptions
 The firm is able to forecast its cash needs with certainty.
 The firm’s cash payments occur uniformly over a period of time.
 The opportunity cost of holding cash is known and it does not change over time.
 The firm will incur the same transaction cost whenever it converts securities to cash.
The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is,
the return foregone on the marketable securities. If the opportunity cost is k, then the firm’s
holding cost for maintaining an average cash balance is as follows:
HC = K (C/2)
The firm incurs a transaction cost whenever it converts its marketable securities to cash.
Total number of transactions during the year will be total funds requirement, T, divided by the
cash balance, C, i.e., T/C. The per transaction cost is assumed to be constant. If per transaction
cost is c, then the total transaction cost will be:
TC = b (T/C) where: b= Conversion Cost per Transaction
The total annual cost of the demand for cash will be:
The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for

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 the optimum cash balance is as follows:
C* = √ 2 bT / K
B. The Miller - Orr Model
The Miller-Orr Model provides a formula for determining the optimum cash balance, the point
at which to sell securities (lower limit) and when to invest excess cash (upper limit).
The Miller-Orr Model provides a formula for determining the optimum cash balance, the point
at which to sell securities (lower limit) and when to invest excess cash (upper limit).
Depends on:
 transaction costs of buying or selling securities
 variability of daily cash
 return on short-term investments

√
3
Z= 3 XTCX
V +L
4r
Where: Z = Optimal Cash Balance, TC = transaction cost of buying or selling securities, V =
variance of daily cash flows, r = opportunity cost per day and L = minimum cash requirement
The upper limit for the cash account (H) is determined by the equation:
H= 3Z - 2L
Where:
Z = Optimum cash balance
L = Lower limit
4.4. Inventory Management
4.4.1. Techniques for managing inventory
Techniques that are commonly used in managing inventory are:
ABC system
ABC analysis is based on economic principle of economist Vilfredo Pareto which state that
most of the economic productivity comes from only a small parts of the economy i.e. in any
large group there are “significant few” and “insignificant many”. In this system inventory is
divided into three groups, A, B and C.
The A group includes those items that require the largest birr investment. They consume
nearly 70% of inventory cost and 10% of inventory quantity. The B group consists of the items
accounting for the next largest investment. Their consumption cost 20 percent and they have a

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 quantity contribution of 20% for the firm's total inventory size. The C group typically consists
of a large number of items accounting for a relatively small birr investment. They constitute
70% inventory quantity and 10% of inventory investment at a firm.
Control of A items should be most intensive and the use of perpetual inventory record keeping
is appropriate. B items are frequently controlled through Periodic checking- possibly weekly-
of their levels. C items could be controlled by using unsophisticated procedures such as a red
lining method.
Economic Order Quantity (EOQ)
It is most commonly cited sophisticated tools for determining the optimal order quantity for an
item of inventory. It takes into account various operating and financial costs and determines
the order quantity that minimizes total inventory cost.
Excluding the actual cost of the merchandise, the costs associated with inventory can be
divided into three broad groups: order costs, carrying costs, and total costs.
Order costs: it includes the fixed clerical costs of placing and receiving an order- the cost of
writing a purchase order, of processing the resulting paperwork, and of receiving an order and
checking it against the invoice. Order costs are normally stated as birr per order.
Order cost = O x S/Q
Where O is order cost per order
S is usage in units per period
Q is order quantity in units
Carrying costs are the variable costs per unit of holding an item in inventory for a specified
time period. These costs are typically stated as birr per unit per period. Carrying cost includes
storage costs, insurance costs, the cost of deterioration and obsolescence, and most important,
the opportunity, or financial, cost of tying up funds in inventory.
Carrying cost = C x Q/2
Where C is carrying cost per unit per period
Q is order quantity in units
Total cost is defined as the sum of the order and carrying costs. Total cost is important in the
EOQ model, since the model’s objective is to determine the order quantity that minimizes it.
EOQ = √ 2 XSXO/C
Reorder Point

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 Once the firm has calculated its economic order quantity, it must determine when to place
orders. A reorder point is required that considers the lead time needed to place and receive
orders. Assuming a constant usage rate for inventory, the reorder point can be determined by
the following formula
Reorder point = lead time in days x daily usage
For example, if a firm knows that it requires 10 days to place and receive an order, and if it
uses five units of inventory daily, the reorder point would be 50 units (10 days x 5 units per
day). Thus as soon as the firm’s inventory level reaches 50 units, an order will be placed for an
amount equal to the economic order quantity. If the estimates of lead time and daily usage are
correct, the order will be received exactly when the inventory level reaches zero.
MRP system
It is a system to determine what to order, when to order, and what priorities to assign to
ordering materials. MRP uses EOQ concepts and a computer to compare production needs to
available inventory balance. The advantage of the MRP system is that if forces the firm to
more thoughtfully considers its inventory needs and plan accordingly. The objective is to
lower the firm’s inventory investment without impairing production.
Just in time (JIT) system
It is inventory management system that minimizes inventory investment by having material
inputs arrive at exactly the time they are needed for production. Ideally, the firm would have
only work in process inventory. Since its objective is to minimize inventory investment, a JIT
system uses no, or very little, safety stocks. Extensive coordination must exist between the
firm, its suppliers, and shipping companies to ensure that material inputs arrive on time.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining
efficiency by emphasizing quality in terms of both the materials used and their timely delivery.
4.5. Receivables Management
Generally, the firm’s financial manager directly controls accounts receivable through
involvement in the establishment and management of: credit policy, which includes
determining credit selection, credit standards, and credit terms, and collection policy
A firm’s credit selection activity involves deciding whether to extend credit to a customer and
how much credit to extend. Appropriate sources of credit information and methods of credit
analysis must be developed.

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 The five C’s of Credit
1. Character: the applicant’s record of meeting past obligations- financial, contractual, and
moral. Past payment history as well as any pending or resolved legal judgments against the
applicant would be used to evaluate its character.
2. Capacity: the applicant’s ability to repay the requested credit. Financial statement analysis
with particular emphasis on liquidity and debt ratio is typically used to assess the applicant’s
capacity.
3. Capital: the financial strength of the applicant as reflected by its ownership position.
Analysis of the applicant’s debt relative to equity and its profitability ratios are frequently used
to assess its capital.
4. Collateral: the amount of assets the applicant has available for use in securing the credit. A
review of the applicant’s balance sheet, asset value appraisals, and any legal claims filed
against the applicant’s assets can be used to evaluate its collateral.
5. Conditions: the current economic and business climate as well as any unique circumstances
affecting either party to the credit transaction. For example, if the firm has excess inventory of
the item the applicant wishes to purchase on credit, the firm may be willing to sell on more
favorable terms or to less creditworthy applicants.
The credit analyst typically gives primary attention to the first two C’s – character and
capacity- since they represent the most basic requirements for extending credit to an applicant.
Collection Policy
It is the set of procedures for collecting accounts receivable when they are due. The
effectiveness of this policy can be partly evaluated by looking at the level of bad debt
expenses. This level of depends not only on collection policy but also on the policy on which
the extension of credit is based. If one assumes that the level of bad debts attributable to credit
policy is relatively constant, increasing collection expenditures can be expected to reduce bad
debts. Popular approaches used to evaluate credit and collection policies include the average
collection period ratio and aging accounts receivable.
Types of Collection Techniques
A number of collection techniques are employed. As an account becomes more and more
overdue, the collection effort becomes more personal and stricter. The basic techniques are:
A. Letters: after an account receivable becomes overdue a certain number of days, the firm

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 normally send a polite letter reminding the customer of its obligation. Collection letters are the
first step in the collection process for overdue accounts.
B. Telephone calls: if letter prove unsuccessful, a telephone call may be made to the customer
to personally request immediate payment
C. Personal visits: sending a local salesperson or a collection person to confront the customer
can be a very effective collection procedure.
D. Using collection agencies: a firm can turn uncollectible accounts over to a collection
agency or an attorney for collection. The fee for this service are typically quite high; the firm
may receive less than 50% on accounts collected in this way.
E. Legal action: legal action is the most stringent step in the collection process. It is an
alternative to the use of a collection agency. Not only is direct legal action expensive, but it
may force the debtor into bankruptcy, thereby reducing the possibility of future business
without guarantying the ultimate receipt of the overdue amount.

Model Questions
1. Using the Baumol Model, answer the following. Assume the following. The interest rate is
7% per month. The ATM fee (transaction cost) for withdrawing money is br. 0.5. Your
monthly income is br. 28,000. You make equal-sized cash withdrawals for each trip you go to
the bank. Given this information, explain the following:
a. What is the optimal number of trips you will make to the ATM each month?
b. What is your optimal average monthly money demand (money in your wallet, not the
bank)?
c. If you decide to go more often to the bank, why would this be less optimal? Explain
d. If you decide to go the bank less often, why would this be less optimal? Explain
2. Chalo Limited provides the following information about its cash management system.
 The annual yield on marketable securities is 3.65 percent.
 The fixed cost of per transaction of marketable securities transaction is br. 1,000.
 The standard deviation of the change in daily cash balance is br. 20,000.
 The minimum cash balance is br. 80,000.
Required: Calculate the Return Point and the Upper Limit using Miller-Orr model.
3. A company plans to apply ABC system to control its inventories. It has 10 types of
inventories as presented in the table below. The table shows the inventory items along with

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 their actual number of sales and cost per unit. Classify the inventory items as A, B and C.
Products Actual number of items sold Costs per unit

Beds 5,000 $80

Chairs 1,500 $20

Coffe tables 700 $40

Desks 600 $40

Ottomans 500 $30

Dining table 700 $50

Book cases 600 $15

Office chairs 10,000 $20

Wardrobes 600 $40

Computer cabinet 700 $30

Chapter Five Current Assets Financing

objectives After completing this chapter students should be able to:
 Suggest the best current assets financing policy to a firm
 understand the pros and cons of short term financing
 Internalize short term sources of finance
5. Comprehensive Notes
5.1. Alternative Current Assets Financing Policies
Most businesses experience seasonal and/or cyclical fluctuations. For example, construction
firms have peaked in the spring and summer, retailer’s peak around Christmas and the
manufactures who supply both construction companies and retailers follow similar patterns.
Similarly, virtually all businesses must build up current assets when the economy is strong, but
they then see off inventories and reduce receivables when the economy slacks off, still, current
assets rarely drop to zero-companies have some permanent current assets, which are the
current assets on hand at the low point of the cycle. Then, as sales increase during the

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 upswing, current assets must be increased and these additional current assets are defined as
temporary current assets. The manner in which the permanent and temporary current assets are
financed is called the firm’s current asset financing policy.
(a) Maturity Matching (Self-Liquidating) Approach
The maturity matching, or “self-liquidating”, approach calls for matching asset and liability
maturities. This strategy minimizes the risk that the firm will be unable to pay off its maturing
obligations.
(b) Conservative Approach
In this situation, the firm uses a small amount of short-term, non-spontaneous credit to meet its
peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the
form of marketable securities.
(c) Aggressive Approach
Relatively aggressive firm finances all of its fixed assets with long-term capital and part of its
permanent current assets with short-term, no spontaneous credit. There can be different
degrees of aggressiveness.
For example, all of the permanent current assets and part of the fixed assets can be financed
with short-term credit; this would be a highly aggressive, extremely no conservative position
and the firm would be very much subject to dangers from rising interest rates as well as to loan
renewal problems.
Permanent Current Assets can be described as assets that are supposed to be maintained by
the business over the course of time in order to ensure that the company is able to run its
operations. These assets are considered to be current assets that tend to stay persistent on the
balance sheet of the company over the course of time. Regardless of the fact that the figures
within these accounts change and fluctuate from one year to another, yet these categories of
accounts will stay intact.
However, they are still classified as ‘current’ assets, because they are expected to convert into
cash over the period of the current year. In other words, they are categorized as current assets
because the time to the liquidation of these current assets is within a time frame of 12 months,
and hence, by definition of current assets, they are classified as such.
Example of permanent current assets include inventory, accounts receivable and cash
Temporary current assets can be defined as any current asset that is not pivotal for the

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 company’s existence, and therefore, having those assets are good, but is not entirely essential
for the survival of the company. All current assets which are on a temporary basis on the
balance sheet of the company are categorized as temporary current assets.
Example of temporary current assets include seasonal inventory items and prepaid rent
(or any other utility)
Permanent Current Assets vs Temporary Current Assets
The underlying difference between permanent current assets and temporary current assets is
the fact that temporary current assets, as suggested by the name, are current asset classes that
exist on the financials for a short while.
A business may, or may not have temporary current assets at the end of a given financial year.
Just like permanent current assets, they are assets the utility of which is expected to be derived
within a period of 12 months. Hence, it is classified as a current asset.
In the same manner, it can also be seen that temporary current assets tend to fluctuate with
time, and may or may not exist, at all on the balance sheet.
5.2. Short-Term Financing
Short-Term Financing is a need for money for a short period of time, i.e., less than a year. It is
one of the primary function of finance that manages the demand and supply of capital for an
interim period, and these funds can be secured or unsecured. To use such funds total financing
funds should be driven by the company, and the company gets directed by the risk-return
trade-off for this decision.
The reason behind choosing short-term financing instead of long-term financing is its
flexibility, cost and advantages although it has high risk than long-term financing.
Sources of Short-Term Financing
1. Trade Credit: Trade Credit is also known as accounts payable.
2. Bank Finance: Bank credit has two forms, i.e., unsecured and secured credit. Unsecured
credits are those that are not covered by collateral securities, and collateral securities cover
secured Credits.
The ways of borrowing a sum from the bank are as follows:
 Working capital loan
 Discounting of bill
 Overdraft

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  Letter of credit
 Cash credit
3. Accrued Expenses: The expenses which have already been acknowledged in the books
before it has been paid are known as accrued expenses.
4. Deferred Revenues: Deferred revenue refers to a part of the firm’s income that has not
been acquired, but pre-payment has already received by the customers.
5. Commercial Papers: These are for financing of Trade credits, payroll and meeting
additional short-term liabilities and commercial paper ranges from 15 days to 1 year.
6. Letter of Credit: The Letter of Credit shows the pledge of the buyer to the seller for
making the payment. This document is issued by the bank, safeguarding the prompt and full
payment to the seller. If the buyer fails to do so, the bank becomes liable to pay the amount to
the seller, for issuing a letter of credit bank charges a percentage of the amount from the buyer
and is delivered against the pledge of securities.
Advantages of Short-Term Financing
Easy to Obtain: Creditors make short-term funds easier to obtain as the risk involved in
delivering loan varies according to payment time.
Less Risky: In Comparison with long-term financing, short-term financing is less risky, as
creditors grant credit for a short period of time.
Resilience: Short-term financing provides resilience as the borrower may adopt alternative
sources of credit after negotiating the short-term credit account by debtors.
Disadvantages of Short-Term Financing
Mature More Frequently: Firm’s producing capital goods worries more often about short-
term creditors as they produce slow-moving inventories, and short-term financing creates a
tight position for a firm more often. If short-term liabilities do not get settled timely, the
creditors may demand closure of the firm.
Costly: When general economic outlooks and collateral elements are considered, short-term
finances at times look costlier than long-term finances.

Model Questions
1. Firms finance their assets with a combination of short term and long term financing. The
following table exhibits this relationship for a particular firm.
Assets Finance Sources

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 Short term Long term

Permanent current assets No Yes

Temporary current assets Yes Yes

Fixed assets No Yes

Which policy best characterizes this firm's asset financing?

2. Compare and contrast the three current assets policies in terms of liquidity, profitability and
working capital need.
Books to Read
E. Brigham & J. Houston (2007), “Fundamentals of Financial Management (11 th edition)”,

USA: Thomson Corporation.

Ross et al. (2003), “Fundamentals of Corporate Finance (6 th edition, alternative edition)”,

USA: McGraw-Hill Companies, Inc.

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