Risk Return Trade Off in Short Term Source of Finance

This article discusses the risk-return trade-off that companies should consider when selecting different sources of short-term financing for their working capital requirements. It explores the relationship between risk and return, and provides examples of short-term financing options. The article also highlights the factors that influence the choice of short-term finance and the risks associated with it. The importance of managing working capital effectively for optimal profitability is emphasized.

RUNNING HEAD:RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE 1
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RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE 2
Question 3 (15 marks)
AVER Ltd is considering short term financing for its working capital requirement. You are
invited to provide a discussion on the risk-return trade-off that the company should consider in
selecting different sources of short term financing. In your discussion, illustrate with an
appropriate example where possible. Write between 1,200 – 1,400 words for this question.
INTRODUCTION.
Decisions that involves working capital requirements of a particular company varies from company to
company across various industries and take various forms with various courses of actions. The risk
involved is such finances must be commensurate to with the level of returns it will bring to the entity.
For the company to be very effective in its operation, it must clearly manage its working capital well and
give specific goals to be attained. These main goals are to get optimal profits and ensure that it has
enough cash in order to meet its short term obligations as and when they fall due and for smooth
continuity in operation.
Profitability of an entity is in line with the theory of shareholder’s wealth maximization such that
investment should only be made by a firm if the return of such investment brings the required return to
the entity (Jones & Felps, 2013).
A company may also decide to have enough cash instead of investing for operational and speculative
motives
The correlation that exists between the return and the associated risks is expressed as follows:
Rate of return(required)=RISK FREE RATE+expected inflation+RISK PREMIUM
When the risk is high therefore, the return will be high in order to provide for equity or to cancel out its
effects.
TYPES OF SHORT-TERM SOURCES OF FINANCE
Bank loan-this either can be in cash credit or overdraft that involves withdrawing more than what you
have in the account. This provide a very short term funds to the entity.
Bank guarantee-this involves obtaining of letters or bank guarantee to acquires short term funds

RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE 3
Deferred payment strategy-this involves delaying some payments of due debts and bills such as taxes,
rent, electricity in order to acquires funds for the short term use in the company. This pending bills can
therefore be paid in instalments thus providing interest free source of funds.
Discounting of bills. This is usually done through banks and it involves cashing out before elapse of a
credit time.
Commercial papers and factoring. Factoring involves sale of debts of the entity to a collection house at a
reduced value than what is actually due. This will provide funds to the company for working capital
requirements (Carbo, Rodriguez & Udell, 2016).
WORKING CAPITAL CONCEPT
This refers to the current assets less current liabilities. Every company should have liquid cash in order to
finance its daily operations like minimum stock required and maintain its account receivable. Working
capital therefore ties liquid cash in stock and accounts receivable even though these items are less
profitable. therefore, working capital comprises a trade-off between company’s liquidity and the
profitability (Ehlers, 2014).
RISK RETURN TRADE OFF
High levels of risks are associated with high chance of a higher levels of returns and the low risks levels
are associated with the great chance of minimal returns. The tradeoff that a potential investor faces while
making such investment decisions is what is referred to as risk return trade-off (Mathuva, 2015).
Short-term source of finance for a company normally involves getting funds for the operation of an entity
and do not exceed one year.
RISK AND RETURN RELATIONSHIP
The key fundamental concept in finance is the relationship that exist between the risk and return. Risk
return tradeoff is also known as iron stomach test in finance. This refers to a situation where an investor
tries to strike a balance between highest return and the lowest risk that is possible.in finance, situations of
low levels of uncertainties are normally associated with low levels of returns. The basic reason is that
investors who take additional risk must be compensated for such. This one therefore places an investor on
a point that he/she must make a decision on the amount of risk he has to take (Baños, García & Martínez,
2010).
Every manager makes decisions that are geared towards shareholder’s wealth maximization and prudent
working capital management.

RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE 4
RISK ASSOCIATED WITH SHORT TERM FINANCE.
LIQUIDITY
This refers to lack of funds to finance obligations that have fallen due. This might therefore cost the
company concerned in various ways such as reputation loss and adverse working environment with
various stakeholders such as creditors.
OPPORTUNITY LOSS
This refers to having too little stock that is not able to sustain production and sales thus resulting in profit
loss due to lack of sufficient funds to support high stock levels.
EXAMPLE TO ILLUSTRATE RISK RETURN TRADE OFF
Company X and Y are two similar companies and carries out similar types of business. Company Y has
made an investment of $3000 a security bond financed by equity that is the company announced its shares
and made sales of $3000 on the same. Company X has current ratio of 3 and gets returns at the rate of 9
% on its total assets but company Y with high investment in security bonds and has current ratio of 3.5
and gets returns of 7% before tax on its total investment. this shows a risk return trade off that is involved
in holding more cash in security investment (Avadhani, 2009).
FACTORS INFLUENCING CHOICE OF SHORT TERM FINANCE.
RISK INVOLVED.
In short term financing, an entity takes out funds because they need quick funds to finance its operation.
This will place the company in a situation of not being able to get access to another source of finance. The
company must therefore consider the risk that is associated with acquiring the short term funding (Kling,
Paul& Gonis, 2014).
INTEREST RATES
The cost of short term finance is usually very high and the company is usually faced with such trade off
of reaping maximum benefits and being charged high interest rates. The company must therefore consider
this risk factor and ensure that it is not detrimental to its operation.
REPUTATIONAL THAT THE COMPANY HAS FROM THE PUBLIC
This is concerned with the company that might be having some pending environmental or other social
issues that the general public can highly scrutinize with regard to the asset that the company want to use
as collateral to acquire such funds. This will limit its access to short term funds (Thomas, 2013).

RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE 5
LEVEL OF INFLATION
This refers to the situation where prices of goods and services are considerably rising uncontrollably. This
is a risk factor that the entity must consider while choosing a short term source of finance since it will
greatly impact negatively on the operation of the company if not well seen. The company will therefore
have to consider the inflationary situation that exists and that is expected to prevail in future. The effect of
this is that, in case of rising inflation, discount rate will consequently reduce. The company should
therefore consider the inflation level in choosing a particular finance (Ross, Wester field, Jaffe & Jordan,
2013
In conclusion, there is a conflicting interest between holding cash by the company to meet its day to day
operation and short term obligations and investing such funds in other activities in order to generate
profits. Shareholders expect maximum return on their investments while the concept of working capital
requirement needs a company to maintain some level of liquid cash to meet its short term obligations. The
company should therefore try to strike a balance between the returns and the risks of going into liquidity
problems.

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REFERENCES.
Avadhani, V. A. (2009). Securities Analysis and Portfolio Management. Himalaya Publishing House.
Baños‐Caballero, S., García‐Teruel, P. J., & Martínez‐Solano, P. (2010). Working capital management in
SMEs. Accounting & Finance, 50(3), 511-527.
Carbo‐Valverde, S., Rodriguez‐Fernandez, F., & Udell, G. F. (2016). Trade credit, the financial crisis,
and SME access to finance. Journal of Money, Credit and Banking, 48(1), 113-143.
Ehlers, T. (2014). Understanding the challenges for infrastructure finance.
Jones, T. M., & Felps, W. (2013). Shareholder wealth maximization and social welfare: A utilitarian
critique. Business Ethics Quarterly, 23(2), 207-238.
Kling, G., Paul, S. Y., & Gonis, E. (2014). Cash holding, trade credit and access to short-term bank
finance. International Review of Financial Analysis, 32, 123-131.
Mathuva, D. (2015). The Influence of working capital management components on corporate profitability
Ross, S. A., Westerfield, R., Jaffe, J. F., & Jordan, B. D. (2013). Corporate finance (pp. 353-54).
McGraw-Hill/Irwin.
Thomas, W. A. (2013). The Finance of British Industry, 1918-1976. Routledge.