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 organization, 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 end that, 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 organization’s funds may remain underutilized, 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.
Working Capital Financing – What It Is And How To Get It?
Working capital financing or working capital policy is defined as the funds that a business needs to finance its daily operations and cover its short-term expenses such as salaries, rent, inventory purchases, and other expenses. Working capital is essential for the smooth functioning of any business, and it is important for businesses to have sufficient working capital to operate efficiently.
There are several ways to get working capital financing, including:
Banks offer different types of loans that can be used to finance working capital, such as lines of credit, term loans, and asset-based loans.
This type of financing allows businesses to borrow money against their outstanding invoices. The financing company will pay a percentage of the invoice amount upfront and then collect the full amount from the customer when the invoice is due.
This is when suppliers allow businesses to buy goods and services on credit and pay later. This can provide a short-term source of working capital financing.
Crowdfunding platforms can be used to raise funds from a large number of people who are interested in supporting a business.
Factoring involves selling accounts receivable to a third-party company at a discount in exchange for immediate cash. This can help businesses with cash flow problems.
To get working capital financing, businesses will need to provide the lender or financing company with financial statements, business plans, and other documentation to demonstrate their creditworthiness and ability to repay the loan. It is important to shop around and compare different financing options to find the best fit for your business’s needs.
What Are The Different Types of 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 optimize working capital financing for a business, namely, hedging, aggressive, and conservative, as per the risk levels involved.
1. Conservative Policy
An organization undertakes this strategy only when it requires minimizing 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.
Organizations majorly utilize 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 underutilization of funds, thus cutting down on returns and compromising growth.
2. Aggressive Policy
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 minimized by ensuring timely payments or minimum credit sales. At the same time, management also maintains that payments to creditors are delayed to the furthest.
Organizations 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 the 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 organizations 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.
4. Maturity Matching Policy
This policy involves matching the maturity of the company’s assets and liabilities. For example, if a business has long-term assets, it will finance them with long-term liabilities. This policy reduces the risk of liquidity problems and helps ensure that the business can meet its obligations as they come due.
5. Liberal Policy
This policy involves using short-term financing to fund long-term assets, which can be risky but also provides the potential for high returns. This policy is typically used by businesses that are confident in their ability to generate sufficient cash flows to meet their obligations.
Comparison Of Working Capital Financing Policies
When considering an ideal financing strategy for your organization, taking into account the following parameters may benefit you:
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.
The 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, the 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.
Benefits of Working Capital Financing Policy
Working capital financing is a valuable option that offers numerous benefits for businesses of different types and purposes. Let’s explore the key advantages of utilizing working capital financing:
Covering Expenditure Gaps: Ensuring Business Continuity
Working capital financing plays a crucial role in keeping businesses afloat by providing the necessary funds to bridge payment gaps and meet their working capital requirements. It enables small and growing businesses that rely on accounts payables to fuel their working capital to support their daily operations without the need for equity transactions. This financial solution ensures a steady flow of capital, allowing businesses to meet their financial obligations and sustain their operations effectively.
Zero Collateral Requirement: Strengthening Financial Position
Businesses with good credit ratings can benefit from unsecured working capital finance, eliminating the need to provide collateralized assets as security in case of default. This aspect enhances the credibility of the business and allows it to access funds without risking valuable assets. By leveraging this financing option, businesses can strengthen their financial position and demonstrate their creditworthiness to potential investors and partners.
Faster and Flexible: Meeting Immediate Cash Flow Needs
One of the primary reasons businesses seek working capital financing is to address their immediate cash flow requirements. Lending institutions understand the urgency of such situations and prioritize the quick processing of working capital finance applications. This ensures that businesses can swiftly revive their operations and maintain their financial stability. Moreover, these financing options come with flexible repayment terms, tailored to accommodate the unique circumstances of each business. Interest rates may vary based on industry risk and the specific business model, providing businesses with a viable and customizable financial solution.
Positive Impact on the Turnover Ratio: Strengthening Financial Health
To truly comprehend the benefits of working capital financing, it is essential to familiarize yourself with the concept of the working capital turnover ratio. This ratio reflects a business’s ability to meet its current obligations and indicates its future working capital financing requirements. By effectively utilizing working capital financing, businesses can optimize their turnover ratio, ensuring efficient cash flow management and reinforcing their overall financial health.
Aligning with Cash Flow Capabilities: Making Informed Decisions
While working capital financing offers significant advantages, it is crucial for businesses to assess their cash flow capabilities before pursuing this option. It is essential to have sufficient cash flow to meet periodic payments associated with this form of financing. If a business has an unproven track record or limited cash flow, it may be prudent to consider collateralized contracts until the credit rating improves. This strategic approach ensures responsible decision-making and allows businesses to explore the best working capital loans options for their specific circumstances.
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.