Financial policy : Question 5
What problems arise when measuring financial equilibrium?
That's a tough question as there is no equilibrium in the true sense of the word in corporate finance.
As Modigliani and Miller have shown, there is no optimum financial structure (split of financing of capital employed between debt and equity). All financial structures have their place and whether they are acceptable or not depends only on the level of risk that the shareholders are prepared to run. A highly geared company will thus be more profitable, all other things being equal, than a company without debts, but it will also carry more risk. Neither situation is better than the other: they are simply equivalent with different risk/reward ratios.
In the short term, we could describe financial equilibrium as the ability of a company to meet its debts at all times. It's thus essentially a liquidity problem. This will depend on:
- the amount of short term liabilities relative to the amount of short term assets: if you have short term liabilities of 10, and short term assets of 7, and you cannot either reschedule your debts or raise new funds, you may as well file for bankruptcy. This information on a company is generally easy to assess and is what we call working capital.
- how quickly your assets become liquid and how soon you have to pay off your debts. This information is not made public and external analysts are hard pressed to estimate it. Internally, it's the ABC of any finance director's key indicators.
For more information, see chapter 35 of the Vernimmen.
As Modigliani and Miller have shown, there is no optimum financial structure (split of financing of capital employed between debt and equity). All financial structures have their place and whether they are acceptable or not depends only on the level of risk that the shareholders are prepared to run. A highly geared company will thus be more profitable, all other things being equal, than a company without debts, but it will also carry more risk. Neither situation is better than the other: they are simply equivalent with different risk/reward ratios.
In the short term, we could describe financial equilibrium as the ability of a company to meet its debts at all times. It's thus essentially a liquidity problem. This will depend on:
- the amount of short term liabilities relative to the amount of short term assets: if you have short term liabilities of 10, and short term assets of 7, and you cannot either reschedule your debts or raise new funds, you may as well file for bankruptcy. This information on a company is generally easy to assess and is what we call working capital.
- how quickly your assets become liquid and how soon you have to pay off your debts. This information is not made public and external analysts are hard pressed to estimate it. Internally, it's the ABC of any finance director's key indicators.
For more information, see chapter 35 of the Vernimmen.