Do you know what financial slack is? Basically this concept is equivalent to a company’s safety margin and it’s directly linked to sectoral debt and some other concepts which are part of the institution.
Also known as “relative debt,” financial slack offers pros and cons in terms of the capital structure of companies and that’s why it’s important to decide how to work with it.
If you are unfamiliar with this concept, don’t worry! In today’s post we’ll tell you all about it and if it plays a determinant role or not in the structure of your business. Read on!
Definition of financial slack
The financial slack is unused capacity for debt and is equivalent to the unutilized cash that a company has on hand. This extra money is available to help a company survive difficult times, such as decreases in sales, revenues or profits.
However, a lot of slack can cause problems such as difficulties in controlling company savings and management discipline, for example.
Presence in a company
The situation which represents the relative indebtedness of a company is when its liquid circulating capital (LCC) — also known as its liquid cash flow (LCF) — is positive.
The LCF represents financial resources from non-current liabilities that finance current assets (CA). When it is positive, current assets are also financed by long-term resources.
Calculation of LCF
LCF = CA – Current Liabilities
When the LCF is zero, it means that the company’s current assets are financed only by short-term financing, which are current liabilities. The long-term financial resources are non-current liabilities.
When the LCF is negative, the short-term resources are financing current assets as well as non-current assets. In this situation the company doesn’t have enough funds to pay its bills.
A company’s liquidity is another safety margin indicator. If the institution is getting lower returns than the market, it may have less cash on hand than other companies. Or in other words, it is less liquid — a fact that can complicate the evolution of the company and vice-versa.
Liquidity is directly linked to the company’s cost of capital (COC), since it can be measured through a minimum attractive rate (MAR) — which, in turn, can be influenced by liquidity. A company with less liquidity has greater risk, and thus attracts less investment.
Minimum Attractive Rate
MAR = RFR+Bx (ER-RFR)
RFR (risk free rate), B (risk coefficient) and ER (expected return).
Considering the economic security of a company over the long term, one has to observe this together with the debt in its sector. The result is a scenario in which providers of financial resources control the offer of capital to manage their risk and exposure considering the characteristics of the sectors to which these companies belong.
Sectoral indebtedness is a target which indicates median company debt for this sector. There’s evidence that the difference between the capital structure of activities and sectoral indebtedness tend to stabilize over the long term.
Offers and demands for funds, are values that sectoral indebtedness uses in determining capital structure. Companies with similar characteristics require the same volume of capital, and credit providers use the median sectoral risk of the operation to limit the degree of leverage.
This concept, evaluated as the influence of the model of relative indebtedness and sectoral indebtedness on the reformulation of a company’s capital structure, shows that a company’s indebtedness tends to follow the sectoral trend, but takes two years to revert to this trend.
The speed of reversion is tied to financial slack, and companies which are further away from the sector’s median indebtedness right themselves more rapidly. Another thing to note is that current liquidity and a large amount of liquid cash flow contribute to better performance.