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 value of the firm for its stakeholders.
A well-made financing policy is important for the growth of the organization in 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 loan, factor receivables, commercial paper, etc. Similarly, the instant requirement of funds can be met by trade credit, outstanding facilities, etc.
The cost of financing for 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 which business should opt for.
Let us have a look at different types of financing policy.
Types of Financing Policy
- Hedging Policy: Hedging policy involves offsetting the finance for an asset with a liability that matures on the expected life of the asset. For example, a business wants to purchase machinery having an expected life of 20 years. It can do so by financing the asset by a 20-year loan. This way the asset and liability both will mature at the same period. The purpose of hedging policy is to match the assets and liabilities during the relinquishing period.
- Conservative Policy: An organization’s attempt to match the assets with the liabilities is not always possible. In such situations, the business uses conservative financing policy. In this policy, the firm uses more of long-term sources of finance and less of short-term finance to purchase its asset. The business acquires the 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 Policy: Aggressive financing policy comprises of relying more on short-term sources of finance then long-term sources. It is termed as 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 the short-term sources of finance.
- Highly Aggressive Policy: A highly aggressive financing policy is one where the major part of the permanent asset is financed by long-term sources and a minor portion is financed by short-term sources. 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 policy. However, there are different aspects that businesses should consider while taking decisions relating to financing policy.
Financing Policy Decisions
- Investment Decisions: Investment decisions of the organization depends on the long term or short term investment requirements. The long-term investment decision involves investment in capital assets of the organization and the short-term investment decision involves working capital management. Financing policy of the firm 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.
- Financing Decisions: The finance manager of an organization needs to select those sources of finance which result in optimum and efficient capital structure. The duty of the finance manager is to select a 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 but it will also result in higher expectations of the shareholders in the form of a higher The financing decisions are based on increasing the wealth of shareholders along with the profitability of the organization.
- Dividend Decisions: Distributing dividends is an important aspect of the business while determining the financing policy. The major concern while taking dividend decision is determining how much profits are available to distribute to the shareholders. Dividend decision must be based on dividend stability policy and future outlook.
If the firm distributes higher dividend and there are growth opportunities for the firm, then it will have to borrow funds from the market to cater to the expansion needs.
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 at a rapid pace.