ii. Financial Constraint

This relates to the prudence needed in managing financial resources. Marris suggested that a prudent financial policy will be based on at least three financial ratios, which in turn set the limit for the growth of the firm. In order to prove their discretion managers will normally create a tradeoff and prefer a moderate debt equity ratio (rj), moderate liquidity ratio (r2) and moderate retained profit ratio (r3). (Let us mention here that the ratios used in the financial constraint are dealt with in detail in any standard text book on Financial Management and are beyond the scope of this book). However a brief description is given hereunder:

(a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners* capital. High value of debt equity ratio may cause insolvency; hence a low value of this ratio is usually preferred by managers to avoid insolvency. However, a low value of r, may create a constraint to the growth of the firm in terms of dependence on high cost capital, i.e., equity.

(b) Liquidity ratio (r2) This is the ratio between current assets and current liabilities and is an indicator of coverage provided by current assets to current liabilities. According to Marris, a manager would try to operate in a region where there is sufficient liquidity and safety and hence would prefer a high liquidity ratio. But a high r2 would imply low yielding assets, since liquid assets either do not earn at all (like cash and inventory), or earn low returns (like short term securities). (c) Retention ratio (r3) This is the ratio between retained profits and total profits. In other words, it is the inverse of dividend payout ratio, i.e., the retained profits are that portion of net profit which is not distributed among shareholders. A high retention ratio is good for growth, as retained profits provide internal source of funds. However, a higher r3 would imply greater volume of retained profits, which may antagonise the shareholders. Hence managers cannot afford to keep a very high value of retention ratio.

Policy variables in Marris’s balanced growth model are as follows:

1. The firm has the freedom to choose its financial policy, as it subjectively determines the three financial ratios, liquidity ratio, leverage/debt ratio and retention ratio.

2. The firm can decide its diversification rate, either by expanding the range of its products, or by merely effecting a change in the style of its existing range of products. OR it can adopt the two policies simultaneously.

3. Price is not a policy variable of the firm. It is a parameter. Price is taken as given by the oligopolistic structure of the market. Production costs are also taken as given.

4. The firm has the freedom to decide the level of it advertising and R&D. Since Price and Production Costs are given, increase in advt. & R&D, will imply lower profit margin and vice-versa.