Academic Journal of Research in Business & Accounting

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Vol. 2, No. 5, May 2014, 7-15 ISSN: 2311-326X




A Framework for the analysis of financial flexibility


Manouchehr Khoramin
1*
& Mohammad Tavanche
2
& MohammadRasoul PoshtPari
3

& Ayesh Hosseini
4
and mohammad Aalian
5









inancial flexibility shows the company's ability to deal with
unexpected interruptions in cash flow. This means the ability to
borrow from various sources, raise capital, sell assets and conduct
operations to meet changing conditions. Development of capital
markets and promoting the culture of profitability, growth opportunities
and flexible firms, and investment needs appropriate infrastructures.
Basically, one of the decisions that have to be done in most companies
is related to the profitability of the firms. Identifying companies with
market mechanisms and characteristics of high flexibility and
profitability for big and small investors and maintaining their rights in
this regard is of great importance.


Keywords: financial flexibility, investment opportunities, dividend policy








1*
Department of Accounting Islamic Azad University, Jenah Branch, , Iran , Manoocher.khoramin@yahoo.com
2
- Department of Accounting ,Islamic Azad University, janah Branch, , Iran , Tavanchemohammad@gmail.com
3
- Faculty of psychology and educational science Islamic Azad University, Jenah Branch,Iran ,
Poshtpari6279@yahoo.com
4
- Mrs.Hosseini, M, Education Ministry of Hormozgan, Jenah, , Iran , Manoocher2012@yahoo.com ,
5
- M_star1666@yahoo.com
Abstract




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Khoramin et al
Introduction
Financial managers should pay due attention to the concept of financial flexibility. In other words,
financial managers must be concerned lest a decision today jeopardize future financing, growth
opportunities and development of the company. This is the very concept of financial flexibility. Lack
of attention to this concept in financing decisions will create a dangerous situation for the company.
Because if at the time required the company fails to provide the necessary resources from financial
markets, it will have to ignore appropriate investment opportunities to due to lack of financial
resources (Higgins 1990).
Therefore, companies are generally concerned about their credit status. This concern isfirstlydue to the
fear of company's inability in paying its major or minor debts and facing financial crisis. Second, the
fear that credit decision today, would jeopardize the company's future financial flexibility. Talk about
corporate credit situation, is important not only for the companies themselves but for other
stakeholders such as creditors and the company's current investors. And potential investors, creditors
will not neglect the credit situation of the company.
The purpose of this paper is to offer a normative framework through which financial flexibility and its
policies and procedures shall be interpreted and mapped. Article is divided into six sections:
1-The life cycle of organizations and financial flexibility
2-Definitions of financial flexibility from a different perspective
3-Indicators of financial flexibility
4-basic resources of flexibility and its financial benefits
5-Classification of different forms and methods of financial flexibility
6-Conclusion and a framework for the analysis of financial flexibility

The life cycle of organizations and financial flexibility
Like all living organisms organizations have a life cycle. Hence there is no unified policy for the
life of organizations and therefore for analysis it should be considered that which of these stages the
organization is at. Categories of financial flexibility for the company has the stages of birth, growth
and maturity. According to Bayoun theory (2008), the companies of birth stage issue stock to finance
and have little leverage. Growth stage companies use debt for financing and the use a lot of leverage.
Maturity stage companies use internal resources and have modest leverage. So these steps can have a
significant impact in making profit, growth and investment opportunities, dividend policy and
corporate values.

The second part is the definition of flexibility from different perspectives:
According to (1984, FASB) financial flexibility is the ability to take effective action to change the
amount and timing of cash flows of the entity so that it is liable to react to unexpected events and






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opportunities. Donaldson (1971) defines financial flexibility from two aspects of cash and short-term
business activities. Due to some activities of business units, the flow of current resulting from past
activities and events and decisions are unlikely to be exactly equal to outflows arising from it. This
definition emphasizes harmony and disharmony of cash flow: such as additional funds that should be
invested or deficit of funds that must be procured from lines of credit. Accounting to information
system accounting has the role of financial flexibility within organizations to plan, build and source of
primary flow of cash to respond to threats and opportunities and unexpected situations. Heath (1978)
defines the companyas flexible that has the ability to perform corrective actions that reduce the need
for increased cash payments. America International Society of Public Accountants (AICPA, 1993)
defines financial flexibility as the ability to do something to reduce the need for cash payments from
predicted resources. Bernstein (1993) defines financial flexibility as the ability of a company to stop
taking unexpected downturn of any reason. According to this view, financial flexibility means the
ability to borrow from various sources in order to raise capital, equity and asset sales and transfers to
adjust the level, and conduct operations in order to deal with changing conditions. Hendrikson and
Brada (1992) defines financial flexibility as a powerful relationship between solvency and liquidity
that are closely integrated together. And they consider hierarchical levels where first flexibility has a
broader concept of the ability to pay the debt and then liquidity.
Volberda (1998) defines financial flexibility as the ability to develop profitable operations and to
impose changes in the business environment as well as the compatibility of anticipated changes that
will affect the company's objectives. Koornhof (1998) defines financial flexibility as the ability to
amend and revise the organizational resources and information in order to comply with environmental
management and strategic goals. Byoun (2007) defines financial flexibility as the capacity and the
speed at which the company can strengthen its finances to be able to take measures to be proactive and
reactive to enhance the level and value of the company. Gamba and Triantis (2008) defines financial
flexibility as the company's ability to access and finance the financial restructuring of the company at a
lower cost. Companies that have greater financial flexibility can avoid the financial weaknesses and
when the opportunities for investment profits come across can provide the credits needed for
investment. Trigeorgis (1993) considers the financial flexibility as some choices available in the
contract with the supplier of investment. For example selecting or canceling from the lender, deciding
for revaluingfrom each of the parties.

Financial flexibility characteristics:
1- Cash available: available cash is one of the most important measures in financial flexibility.
According to Byoun (2008), Arslan et al (2008) and Velay (2005), an institute that has more available
cash has high flexibility. This index is calculated by dividing the total cash to total assets.




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Khoramin et al
2- Unused debt capacity: This capacity helps the companies with investment opportunities have
arisen and is a reflection of financial flexibility Dennis and McQueen (2009). Thus, institutions with
low debt are highly flexible. This is calculated by dividing the total debt to total assets.
3-Z-Score is a criterion for evaluating the financial condition of the company and the lowerthis
criterion, the higher the profitability Daniels et al (2008).

The basic sources of financial flexibility and benefits
Financial flexibility stems from many sources. Based on the literature (De Angelo and De Angelo,
2007) and Daniel et al 2008 Accounting Standards Committee, 1386, etc.), main sources of financial
flexibility can be outlined as below:
1- Maintaining capacity of borrowing external financing or foreign shareholders
2-Maintaining a high level of available cash
3-Ability to access cash by selling assets and keeping operations and investment continuing without
disruption.
4- Reduction or non-payment of dividends between shareholders
5- Raising cash through equity shareholders (internal financing)
Acquiring new funds through short-term bonds6-
7-The ability to tend to rapid improvement in net cash flows from operations
Financial flexibility benefits: improving opportunities, incentives, improving efficiency,
creating a link between payments and practitioners in corporate profits

Forms of Classification and financial flexibility
Heath (1978, p 21) has divided flexibility into 5 categories:
1-Borrowing Money
A) Direct: by borrowing from banks or selling bonds and commercial paper
B) Indirect: by delay in payment of trade creditors and increase in the loan maturity date, etc.
2-Liquidity of assets:
A) Direct: byconsumer documentsthat can be sold or traded, factoring, and reuse assets, machinery
and equipment, etc.
B) Indirect: not a replacement for the factory's assets that are used during an operation
3-lowering the cost
4-Dividend interest cuts
5-Release the capital stock
A similar classification has been offered by Donaldson (1971), Koornhof (1988) and FASB (1980)
which is identified in the following table.







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Based on Daniels et al (2008), there are two methods for financial flexibility:
1-Gearing ratio (debt to assets)
2-Relative liquidity (cash holdings)

A framework for the analysis of financial flexibility and conclusion
For analysis two basic questions are to be answered: 1 - What projects or investment opportunities
are available for companies?2- How would the maximum amount paid to shareholders be?The
direction of the amount paid to shareholders of free cash flow, which is one of the factors the
flexibility could be named. In answer to the first question, various methods of investment
opportunities are expressed:
There are several methods for measuring investment opportunities 1 - book value to market value of
assets (MBA) 2 -book-to-market equity 3- the ratio -4E/Pratio of Tobin Q ratio.
Tobin Q ratio is seen as an equivalent to (MBA) and this is due to the high correlation between these
two measurements.
The ratio of market value of assets (calculated by market shares hold by shareholders and debts) to the
replacement value of assets is called Q Tobin (Tobin, 1969).
Change in
Operational and
investment
operations




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Khoramin et al
Tobin explains that when 1 <qcompany is incentive to invest and when 1> q investments investment
should be stopped.
When 1> q it is possible that acquisition of assets through merging will be cheaper than buying new
assets.And the high value of Q Tobin never represents a valuable growth opportunities.
TobinQ it= 0+1FFit+2Levit +3(LevitFFit)+4Sizeit+5Profitabilityit+6Cashit+ 7Qit +
Where:
Tobins Q: for calculatingQ Tobinfollowing equation can be used that is the index of investment
opportunities in this research:

Where:
Qs = ratio of Tobin Q
MVCS = the market value of the common stock of the company at the end of the year
MVPS = market value of preferred stock in the company year-end
BVLTD = book value of long-term debt at end of year
BVSTD = book value of short-term debt
BVA = book value of corporate owned
FF=Dummy variable for assessing dynamic companies so that points the deviation between the
actual value and the value of 1 for firms that are predicted to be negative for 3 consecutive years and
zero for the rest of companies (non-a flexible)
Q=Rate of book value of total assets minus book value of equity plus market value of equity to
capital stock.
So it can be said that growth opportunities and flexibility are correlated.
FCFE=NI-(CE-D)-(WC)+(ND-DR)
Where:
WC WORKING CAPITAL CHANGES
ND NEW DEBT
NI NET PROFIT
CE CAPITAL EXPENDITURE
DR PREVIPUS DEBT
D DEPRECIATION

To answer the second question free cash flow formula is used:
Financial leverage has an impact of on the free cash flow because one the power tools for repayments
of debt and and the financial flexibility of the company is its outstanding operations which means






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surplus funds. In the above formula, if new debt is equal to previous debts it has no impact on cash
flows and when the new debt is greater than the previous debts of the company, they will increase the
leverage. So with higher financial risk, free cash flow decreases. And if the new debt is less than the
company's previous debt, company reduces its leverage to reduce the and increase the cash flows .
So according this study it can be said that high flexibility creates investment opportunities. And
increased opportunities for investment means using the surplus funds which reduces free cash flow
thus affects flexibility.
To answer the second question, it can be said that with financial leverage, free cash flow and
favorable investment opportunities the companies with free cash flow are flexible so they should not
share their profits. This will increase the investment opportunities and raise the profitability of the
company in the future and from the perspective of investors, it could be a good prospect. Futhermore,
role of conservatism should not be forgotten: increased flexibility is due to conservatism. Flexible
contractual interests allow greater dividend for the company. But from the perspective of distortion of
information, conservative firms are less flexible so they will have less dividends.
In summary, companies with free cash flow to shareholders and good investment opportunities are
better not to divide large profits. Because it reduces investment in the company's and value of the
company never reaches its maximum. Companies that have free cash flow but not a good investment
opportunity are better to divide large profits so that the shareholders use those funds other ways (For
example, invest in other companies).Companies that do not have free flowing but have good
investment opportunities are better reduce their dividends. So as to use these investment opportunities.
Finally, firms do not have free cash flow to shareholders and no opportunities can reduce unfavorable
investments and dividend thus better their status.

Conclusions
Environment where companies are working are developing and highly competitive. To survive,
companies have to compete with many of the national and international level issues to expand their
operations through new investments. Companies need financial resources for investment. But the
financial resources and their use should be determined well so that the company can step in the path of
progress and the profitability. It is task of the financial manager to finance sources and determine
methods to use them. So it could be said that, due to unpredictable changes and competitive
international markets, companies must have the needed flexibility to coordinate with these cases.
Companies should take note of environmental changes and crises, and create this ability in themselves
and become quickly flexible, and create this culture in the company.








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Khoramin et al
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