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How to know whether the company has used long-term or short-term finance & whether the company has used that finance to be invested in long-term assets or short-term assets?
Do we’ve to calculate any specific ratios to know this?
It depends on the information given, but normally you are given the SOFP and can tell from there.
From the SOFP you know what the total long-term finance is, you know how much of it is invested in non-current assets and therefore you know how much is invested in working capital. You also know from the SOFP any short-term borrowings.
I have few questions related to WC Financing & Investment. Please could you clear out my doubts that I put in points. I would be Thankful! 🙂
[I was attempting to question Wobnig Co from BPP kit where we’re told that long-term is $4000 which remains constant & overdraft of $1500 which was increased immensely from one period to another]
1) Seeing this we’re pretty sure that company has raised short-term borrowing (overdraft) to finance its assets. BUT how do we know that the company has invested this finance in short-term assets or long-term assets?
2) Since the long-term borrowing is constant but we can see the increase in fixed assets which is $15,284 in current period. Is it correct that we have used short-term borrowing to finance fixed assets?
3) On the other hand, short-term borrowing is increased immensely which is $1500 in current period & we can see the increase in current assets which is $5,349. Therefore, we can see that company has short-term borrowing used to finance current assets.
4) Do we have to make an assumption that short-term borrowing is used for short-term assets (current assets) & long-term borrowing is used for long-term assets (fixed assets)?
5) Also, there is an interest expense given in SOPL of $355 which has increased from the last year! BUT again how do we know whether this interest is caused by the increase in short-term borrowing or it is caused by long-term borrowing?
6) Is it true that in the exam we’re either given the increase in short-term borrowing & long-term remain constant (like in Wobnig Co) OR we’re given short-term borrowing to be constant & long-term borrowing is increasing [It is either this or that – Is that correct?].
If we’re given that both short-term & long-term borrowings are increasing, then how would we identify whether the increase in interest is caused by the short-term or long-term borrowings!?
The non-current assets have increased by $682. The long term finance has increased by $727. Therefore the difference is invested in working capital. The rest has come from short-term finance.
This answers most of your questions 🙂
The interest on the long-term borrowings is 7% x 4,000 = $280 (it says in the SOFP that they are 7% bonds). Therefore the rest of the interest must be interest on short-term borrowings.
Sir, could you please respond to these questions:
1) Do we have to make an assumption that short-term borrowing is used for short-term assets (current assets) & long-term borrowing is used for long-term assets (fixed assets)?
2) Is it true that in the exam we’re either given the increase in short-term borrowing & long-term remain constant OR we’re given short-term borrowing to be constant & long-term borrowing is increasing [OR examiner can ask both increase in short-term & long-term borrowings in a question?]
3) If we’re given that both short-term & long-term borrowings are increasing, then how would we identify whether the company is using Aggressive Policy or Conservative Policy to finance its assets?
It is not that you assume anything – your job is to interpret the SOFP’s (and any other information given in the question) and be able to therefore state that it suggests they are operating a conservative or an aggressive policy (you can never say for certain just on the basis of one or two SOFP’s).
Non-current assets should always be financed using long-term finance so any extra non-current assets will be using some of the extra long-term finance that has been raised.
You need to look as to how much of the remaining long-term finance raised has been invested in working capital and how much of the extra working capital has therefore been financed from short-term finance.
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