What Are The 3 Working Capital Financing Policies?
Working capital is a significant factor in a company’s operational competency. Proper management of working capital ensures sufficient availability of funds to finance the day-to-day operations of an organisation, as well as, to fulfill growth and expansion targets. Thus, experts often consider it to be a precursor to a business’s success or failure.
To that end, several businesses opt for working capital financing options. However, the policy a business undertakes to finance its working capital is of utmost significance. With an inept policy, an organisation’s funds may remain underutilised, its growth may be hindered, or worse, it could face immense losses.
Thus, it requires a clear understanding of different working capital financing strategies to produce the most optimal results.
What Are The Different Working Capital Financing Policies?
In general, working capital policies involve determining the sources of finance. It also determines the allocation of these finances towards current assets and liabilities. Broadly, three strategies can help optimise working capital financing for a business, namely, hedging, aggressive, and conservative, as per the risk levels involved.
1. Conservative Policy
An organisation undertakes this strategy only when it requires minimising risk to the furthest. Under this policy, the management regulates the credit limits stringently to ensure low risk.
Moreover, current assets are always above par against the current liabilities to ascertain sufficient availability of funds.
Organisations majorly utilise long-term funding options to finance fixed and fluctuating current assets. The use of short-term sources is kept to a minimum for low-risk.
Observing a conservative working capital financing policy, hence, leads to underutilisation of funds, thus cutting down on returns and compromising growth.
As the name may suggest, aggressive policies involve the maximum risk, and thus, also bring the potential for multiplied growth.
When observing this strategy, companies ensure their current assets, such as the value of debtors, are minimised by ensuring timely payments or minimum credit sales. At the same time, management also maintains that payments to creditors are delayed to the furthest.
Organisations aiming at accelerated growth can opt for this working capital policy. However, since it involves immense risk, strong business acumen, and deft handling of finances are critical.
3. Hedging Policy
Also known as matching policy, adopting this strategy ensures that the current assets of a company are always in sync with short-term liabilities.
In essence, this working capital financing policy aims to balance the two extreme strategies, both in terms of risk and growth potential.
Most organisations observing this strategy use long-term sources of finance to invest in fixed current assets and resort to short-term funding options for current asset financing.
Comparison Of Working Capital Financing Policies
When considering an ideal financing strategy for your organisation, taking into account the following parameters may benefit:
While following an aggressive strategy, liquidity is usually low since short-term funds are primarily used to finance both fixed and fluctuating current assets. A company is thus left with minimal idle funds.
Conversely, in the case of a conservative strategy, liquidity is usually high. It is because companies mainly use long-term sources of finance, which leaves them with sufficient idle funds to address emergencies.
Hedging strategy involves moderate liquidity, ensuring a balance between idle funds and their cost.
In a conservative approach, interest cost is higher compared to the other two working capital policies. Thus, naturally, it lowers profits. In general, aggressive policies offer the highest returns since the cost involved is kept to a minimum. As you can guess, in observing the matching strategy, profits generated are moderate.
Working Capital Requirement
Under a conservative approach, the working capital you need to maintain is substantial as it involves the provision of idle capital for exigencies. Under an aggressive strategy, the working capital requirement is notably low, which speaks to high risk, but the cost is saved. When considering the hedging policy, this factor is neither too high, nor too low.
The Bottom Line
Consider these and other factors relevant to your business judiciously before adopting any particular policy. The growth stage of your company at any point in time can be a significant consideration when adopting the working capital financing policy.