Question

Stevens Inc. uses permanent sources of financing to cover its peak level of current assets. When it does not need the money to finance inventories and accounts receivable. It invests the excess funds in short-term certificates of deposit.

a) Explain an advantage and a disadvantage of this policy?

b) Explain how this policy can affect profits.

Answer 1

a. Advantages: As peak level needs of current assets are financed with long-term funds, Stevens Inc. avoids the hassle of making frequent arrangement for short term loans. Secondly, the company is also able to avoid the risks of rising interest rates or a tight credit situation.

Disadvantages : The cost of long-term debt / equity is substantially higher than short term loans. Stevens Inc. is needed to dear interest expense for the whole year, rather than only for the peak periods.

b. The return earned on short-term certificates of deposit would most certainly be far lower than the interest cost associated with long term debt. Therefore, the policy employed by Stevens Inc.impacts profits adversely, i.e profits are lower than would have been had the company employed short term sources of financing to meet peak requirements.