Meaning of Financing Policy
Financing Policy refers to the decisions, choices, or regulations related to the financial system of the organization like payment system, borrowing system, lending system, etc. The policies are framed to introduce financial stability, promote market efficiency and enhance the firm’s value for its stakeholders.
A well-made financing policy is important for the organization’s growth in the long run. A business can show good growth and expand its profitability if the financial aspects are maintained in a transparent manner. Good governance on financial performance and financial policy ensures higher returns on the capital invested. Every organization frames its financing policy depending on its functionality, requirements, suitability, and environment in which it is functioning.
Like, an organization looking for long-term finance can go for financing in the form of equity or preference shares, debentures, etc. For short-term finance requirements like working capital, the organization can borrow funds in the form of bank loans, factor receivables, commercial paper, etc. Similarly, the instant funds requirement can be achieved by trade credit, outstanding facilities, etc.
The cost of financing for the long term is always higher than the short term. However, the risk in short-term financing is always greater. The financing policy of the organization determines the type of borrowing that a business should opt for.
Let us have a look at different types of financing policies.
Types of Financing Policy
Hedging policy involves offsetting the finance for an asset with a liability that matures on the asset’s expected life. For example, a business wants to purchase machinery having an expected life of 20 years. It can do so by financing the asset with a 20-year loan. This way, the asset and liability both will mature in the same period. The purpose of the hedging policy is to match the assets and liabilities during the relinquishing period.
An organization’s attempt to match the assets with the liabilities is not always possible. In such situations, the business uses a conservative financing policy. In this policy, the firm uses more long-term sources of finance and less short-term finance to purchase its asset. The business acquires permanent and current assets using long-term sources of finances. Only a part of short-term finance is used to finance its temporary current assets.
Aggressive financing policy comprises of relying more on short-term sources of finance than long-term sources. It is termed an aggressive policy because it is riskier as it involves the continuous renewal of the borrowing. In this policy, the firm finances its permanent current assets using short-term sources of finance.
Highly Aggressive Policy
A highly aggressive financing policy is one where long-term sources finance the major part of the permanent asset, and short-term sources finance a minor portion. It is a common assumption that the firms which follow this policy are nearing their closure and are termed as “sick.”
Depending upon the strategy and requirements of the organization, it can adopt different types of financing policies. However, there are different aspects that businesses should consider while making decisions relating to financing policy.
Financing Policy Decisions
Investment decisions of the organization depend on the long-term or short-term investment requirements. The long-term investment decision involves investment in the organization’s capital assets, and the short-term investment decision involves working capital management. The firm’s financing policy considers the investment requirements and accordingly arranges for the funds. The interest rates on the long-term funds are comparatively lower than the short-term funds.
The finance manager of an organization needs to select those sources of finance that result in optimum and efficient capital structure. The duty of the finance manager is to select the right proportion of debt and equity in the overall capital mix—higher debt results in higher interest liability and higher risk. By increasing the equity, permanent funds of the business will increase. Still, it will also result in higher expectations of the shareholders in the form of a higher required rate of return. The financing decisions are based on increasing the wealth of shareholders and the organization’s profitability.
Distributing dividends is an important aspect of the business while determining the financing policy. The major concern while making dividend decisions is determining how much profits are available to distribute to the shareholders. Dividend decisions must be based on dividend stability policy and future outlook.
If the firm distributes higher dividends and there are growth opportunities for the firm, then it will have to borrow funds from the market to cater to the expansion needs.
The financing policy of an organization determines the potential of a business organization. The right set of plans, policies, and regulations can help the business grow rapidly.
- Asset Financing – Meaning, Types, Risk Associated and Differences
- Aggressive Approach to Working Capital Financing
- Term Loan or Project Finance – A Long Term Source of Finance
- Conservative Approach to Working Capital Financing
- How to Choose Right Source of Finance for Your Small Business?
- A Comparison between 3 Strategies of Working Capital Financing