The balance sheet portrays the effects of a firm's investing and financing decisions. In analyzing these decisions, what two principles guide financing decisions?

Answer 1

BALANCE SHEET RELATIONS

The balance sheet portrays the effects of a firm's investing and financing decisions. In analyzing these decisions, consider two principles that guide financing decisions:

1 . Matching the duration of the financing with the duration of the asset. Firms use short-term financing for assets they expect to convert to cash in the short run, such as accounts receivable and inventories, and they use long-term financing (debt or shareholders' equity) for assets to be used over long periods, such as property, plant, and equipment.

2 . Linking the mix of long-term financing (debt versus equity) to the nature of long-term assets and the amount of operating risk. Firms with tangible long-term assets and predictable cash flows, such as electric utilities, tend to have balance sheets with a high proportion of long-term debt (80% or more). The property, plant, and equipment are collateral for the borrowing (that is, the lender can repossess the assets if the firm fails to make debt payments on time). Thus, physical collateral reduces the cost of borrowing. Predictable cash flows reduce the risk that the firm will not have sufficient cash to make interest and principal payments when due; this predictability also reduces borrowing costs. Firms with tangible long-term assets and less predictable cash flows, such as auto manufacturers and steel companies, whose sales vary with changes in economic conditions, tend to use a more nearly equal mix of long-term debt and shareholders' equity financing. The property, plant, and equipment serve as collateral for the borrowing, but the more uncertain cash flows suggest a lower proportion of long-term debt in the capital structure. Firms with high proportions of intangibles, whether recognized as assets on the balance sheet or not, tend to rely more on equity financing than on long-term debt. Lacking collateral, lenders must rely on cash flows from operations to service the debt. The less predictable these cash flows, the smaller is the proportion of long-term debt.

The reasoning behind these generalizations about financial structure derives from lenders' and investors' assessments of business risk. Operating risk arises from the asset side of the business, and financing risk arises from debt. Operating risks include variability in sales from changing economic conditions (cyclicality risk) or from short product life cycles (because of technological change or changes in consumer taste). Operating risks also include the variability of earnings that arises when the firm has a high proportion of fixed costs that do not change as sales change, such as depreciation on capital-intensive manufacturing facilities. Firms with substantial operating risk tend not to increase their risk by financing with long-term debt. Long-term debt imposes financing risk because it requires principal and interest payments. The more variable are the firm's cash flows from operating activities, the more risk that the firm will not have sufficient cash to meet the required payments. Failure to meet these obligations can result in default, creditor or regulatory intervention in the management of the firm, or bankruptcy.