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Hello , in this question you are asked to discuss the working capital financing strategy. However, you are provided only with an extract of the SOFP. FA= 48,965 CA=16935 CL=14,000. The CL consists of AP & O/D. The O/D is 3800 being used out of 4000.
In the answer they mention that it is risky since the current assets are funded mostly by the O/D.My question is why? I am now confused as I thought that ideally short term assets should be funded by short term loans and non current assets by long term loans.
If the ‘?’ was meant as a way of pushing for a reply, then please be patient in future and do not do that again.
I am probably in a different time zone than you, I do have to sleep, and I do have to teach during the day (so that we can provide this site free of charge). You cannot expect us to sit at the computer 24 hours a day – I answer questions at 06:00 in the morning before teaching, and then spend most of my evenings answering questions after teaching.We state on the website that questions will be answered within 48 hours, but in fact I answer within 24 hours virtually 100% of the time.
🙂
It is not the case that short-term assets should automatically be funded by short-term money.
What you are confusing it with is that there is an argument that non-current assets should be funded by borrowing of the same period (i.e. if you expect to use the asset for 5 years then maybe fund it by taking a loan for 5 years). This is not however a rule by any means – in all likelihood the asset would need replacing after 5 years (and so we effectively need the funding for a much longer term).With regard to the working capital, even though each individual receivable (for example) is short-term, as each receivable pays another receivable will appear as we keep selling and keep receiving cash. There is a long-term need to finance working capital. If total receivables are on average (say) $10,000 then we are always going to need to finance $10,000. So…….although there is no rule, the general advice would be to fund the long-term average working capital with long-term finance, and to only use short-term finance (overdraft) to fund any day-to-day extra needs.
However, some companies prefer to finance it more from short-term finance because it may be cheaper (we only pay interest on the balance day by day instead of paying on a fixed amount whether we need it or not). But if they do this they are taking on more risk because if the bank decided to call in the overdraft they would have problems. Also if interest rates increased they could have problems (whereas long-term borrowing would be more likely at a fixed interest rate).
I do suggest that you watch my free Introduction lecture on F9, and also my lecture on Overtrading.
Mr Moffat
Firstly , the “?” was not meant to be rude or impolite. As you rightfully said, you answer in a very short time. I saw other questions being answered which were posted after so i thought either my question was not showing up for some technical reason or you inadvertently missed it (especially with so many questions on this forum). You have been a tremendous help to myself and obviously students all over the world. For that I am very much great full and appreciative. Thank you for taking the time to assist and more so free of charge.Secondly, thank you for the explanation. You have made it easier to understand.
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