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Financial flexibility Vs Operating flexibility
Financial flexibility refers to the capability of a company to respond to its cash flow or an investment opportunity set in a timely and value-maximizing manner. The concept of financial flexibility is not new, but the most corporate approach has been via the Miller and Modigliani model of capital structure where the corporate performance is judged in a perfect capital market. Such capital markets are frictionless, and they perform in a costless manner where the firms can enjoy complete flexibility of arranging their capital structure.
Financial Flexibility is Important in Uncertain Times
Financial flexibility plays a critical role only when the markets contain various kinds of frictions. In the presence of the frictions, there may be some firms that have to restrict themselves from undertaking valuable projects or investments. Therefore, corporate firms must have the flexibility to respond to uncertain times when an investment becomes necessary. That is why, most financial managers are of the view that financial flexibility is the most important determinant of a firm's corporate capital structure policy.
In simple words, the financial flexibility of a company is the capability of arranging funds for unexpected financial needs in a timely and organized manner. The companies that have great financial flexibility are capable to meet any future cash flow needs without much effort. That is why, financial flexibility is an important part of the capital structure model of corporate firms.
Many financial experts suggest that there is a relation between financial leverage and the composition of various operating costs, or the operating leverage. Having more operational leverage lets companies have less vulnerability towards bankruptcy and other such problems.
Higher Debt Capacity Implies Higher Operating Flexibility
Operating flexibility or the ability to reorganize the operations according to financial obligations is a great sign of independence in terms of finance for companies. The operating flexibility is often measured by the capacity of a firm to be financed by debt. Since debt is sourced to run the business, it can be stated that the companies that have higher debt capacity also have higher operating flexibility in their capital structure.
It is to be noted here that operating flexibility and financial flexibility are not two independent terms. In fact, there is a true relationship between the two. While financial flexibility refers to the arrangement of debts as a resource to finance operations, operating flexibility refers to the use of the debt for the best financial outcome.
Although both financial and operating flexibilities are theoretically emphasized by the Miller and Modigliani hypothesis, there are practical variations of the concepts in real capital markets. That is why, the financial managers of companies need to take care of other principles such as operating strategy and discounted cash flow, etc., while judging the actual financial and operating flexibilities.
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