The operational capability of a corporation is significantly influenced by working capital. The proper management of working capital guarantees that there are enough resources available to pay for an organization’s ongoing operations as well as to achieve its development and expansion goals. As a result, experts frequently view it as a sign of a company’s potential success or failure.
Many companies choose working capital financing options as a result. However, the strategy a company uses to fund its working capital is extremely important. A bad policy could cause an organization’s funds to remain unused, hamper its growth, or even worse, result in significant losses.
Therefore, to achieve the best outcomes, it is necessary to have a thorough awareness of the various working capital financing techniques.
What Are The Different Working Capital Financing Policies?
Working capital policies typically include identifying the sources of funding. It also affects how these funds are distributed between current assets and liabilities. According to the levels of risk involved, three general strategies—hedging, aggressive, and conservative—can assist a corporation to maximize working capital funding.
1. Conservative Policy
An organization only uses this method when it is necessary to minimize risk. To ensure low risk, the management strictly controls the credit limitations under this policy.
Additionally, to ensure adequate cash flow, current assets must always be greater than current liabilities.
For the most part, businesses use long-term funding solutions to finance their varying and fixed current assets. For low-risk, short-term sources are used as little as possible.
Therefore, following a cautious working capital financing policy results in the underutilization of funds, which lowers returns and compromises growth.
2. Aggressive Policy
Aggressive policies carry the greatest risk, as their name might imply, but they also have the potential for exponential growth.
By making timely payments or limiting credit sales, businesses following this strategy make sure their current assets, such as the value of debtors, are limited. The management further asserts that payments to creditors are being made with the greatest delay.
This working capital policy is an option for organizations looking to grow more quickly. However, due to the high level of risk, sound business judgment and adept money management are essential.
3. Hedging Policy
Adopting this method, also known as a matching policy, guarantees that a company’s current assets and short-term liabilities are always in balance.
In terms of risk and potential for growth, this working capital finance approach essentially seeks to strike a balance between the two extreme options.
Most businesses that follow this strategy invest in fixed current assets with long-term sources of funding and finance current assets with short-term funding choices.
Comparison Of Working Capital Financing Policies
The following factors should be taken into account when deciding on the best financing plan for your company:
When compared to the other two working capital policies, interest costs are higher when using a cautious approach. Naturally, this results in lesser profitability. Since the costs are minimized, aggressive approaches typically provide the largest returns. As you may imagine from viewing the matching approach, the gains made are modest.
Liquidity is typically limited while pursuing an aggressive strategy because short-term funds are largely needed to finance both fixed and cyclical current assets. Thus, a corporation has little money sitting around.
Contrarily, liquidity is typically strong in the event of a conservative strategy. It happens because businesses typically rely on long-term sources of funding, which leaves them with extra cash on hand to deal with catastrophes.
Moderate liquidity is used in hedging strategies to maintain a balance between the cost of idle funds and their benefit.
- Working Capital Requirement
The amount of working capital you must maintain under a conservative strategy is significant because it calls for setting aside idle funds for emergencies. An aggressive strategy has a noticeably low working capital demand, which implies significant risk but saves money. This factor is not too high or too low when taking the hedging strategy into account.
The Bottom Line
Before implementing any given policy, carefully weigh these and other pertinent issues for your company. When deciding on a working capital financing strategy, it is important to take your company’s growth stage into account.