Untitled-29

(^176) Financial Management
of current assets to the firmís operation was indicated in the preceding section; but
without fixed assets to generate finished products that can be converted into cash,
marketable securities, accounts receivable, and inventory, the firm could not operate.
If the firm could earn more money by purchasing its inventory than by producing it or
by investing its money in marketable securities then it should not be in the manufacturing
business. In other words, if a firm cannot make more on fixed-asset investments than
it makes on current-asset investments, it should sell all its fixed assets and use the
proceeds to purchase current assets. In the following discussion it is assumed that the
firm can earn more on fixed assets than current assets.
The cost of financing: The firm can obtain its required financing from either of two
source: (1) current liabilities or (2) long-term funds. Current liabilities are sources of
short-term funds; long-term debts and equity are sources of long-term funds. Since
current liabilities generally consist of accounts payable, notes payable, and accruals,
they are typically a cheap source of funds. Of the basic current liabilities, only notes
payable normally have a stated cost. This is because notes payable represent the only
negotiated form of borrowing. Accounts payable and accruals are cheaper sources
of funds than notes payable since they do not normally have any type of interest
payment associated with them.
Historically, in general, short-term funds cost less than long-term funds. In the recent
past, interest rates have been increasing and people have expected higher interest rates
in the future. Lenders with such expectations will typically provide short-term funds
at rates below those charged for longer-term funds. They do this because short-term
loans mature in less than a year, and they will get their money back in time to relend
it at higher rates if interest rates do increase over the year. If interest rates are
expected to increase in the future, a lender will charge a high enough rate of interest
on a longer-term loan to compensate himself for tying up his money for a long period
and losing future opportunities to lend money at increased rates.
Whenever lenders believe that future interest rates will rise, short-term borrowing
rates are less than long-term rates. When future rates are expected to decline from
a currently high rate, long-term rates are most often below short-term rates. Since
increasing interest rates have prevailed in the most recent past, it is assumed in the
following discussion that short-term funds are cheaper than longer-term funds. The
fact that short-term sources of funds include not only notes payable but also accounts
payable and accruals makes it much easier to accept this assumption, since accounts
payable and accruals are virtually interest-free. The cheapest form of financing for the
business firm is, therefore, short-term funds.
The nature of the trade-off between risk and profitability
If a firm wants to increase its profitability, it must also increase its risk. If it wants to