What are the Approaches to Working Capital Management?

Ruchi Gandhi

09 Jul, 2020

The capital available for the funding of current assets is called working capital. It is the capital of a business that is used to undertake a company’s daily business operations. Working capital management deals with the monitoring and proper utilization of current assets and current liabilities. There are different approaches or policies that finance managers may adopt to manage the availability of funds required to meet working capital requirements. This article is designed to give an insight on different approaches of working capital management which may be taken up by an entity, based on its specific parameters.

Importance of adequate working capital

Working capital management is an essential task for finance managers. They must ensure that the amount of working capital at their disposal is neither too large nor too small for the business needs. Large amounts of working capital would mean idle funds for the firm. Because funds have a cost, the company has to pay huge interest amounts on such funds.

Similarly, if the firm has inadequate working capital, then such a firm runs the risk of insolvency. Lack of working capital may lead to a situation where the company will not be in a position to fulfil its obligations.

Over capitalization means that an organization has too large funds for its requirements, resulting in a low rate of return, a condition that implies a less than optimal usage of resources. A business, hence, has to be very careful in estimating its working capital requirements. Maintaining an adequate working capital is not just pertinent in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business concern in the long-term as well.

Factors influencing investment of working capital

How much to invest as working capital in the current assets is a matter of an entity’s policy decision. The decision must be made in the light of organizational goals, trade policies and financial (cost-benefit) considerations.

Due to their peculiarity, some organizations require more investment than others. For example, an infrastructure construction company needs more investment in its working capital, as there can be a huge inventory in the form of work-in-progress. On the flip side, a firm engaged in fast-food business requires comparatively less investment in working capital.

Hence, the level of investment in working capital depends on the various factors listed below:

• Nature of Industry (manufacturing or trading or service) and types of products

• The volume of sales and the possibility of accounts receivables

• Nature of credit policy, i.e., a firm with liberal credit policy has not only a high level of receivables but also requires more capital to fund raw material acquisitions

• Degree of seasonality which means that companies experiencing strong seasonal movements have special working capital problems

• Production policy of the company and the rate of production maintained

• Growth stage of the business, i.e., an expanding company would require greater amounts of working capital to prevent interruptions to the production sequence

• Competitive conditions which mean that when the competition is intense, there is more pressure to stock varied product lines to meet the demands of the consumer and to offer more favourable credit terms

• Dividend policy adopted by a firm giving consideration to its effect on cash

• Risk factor which signifies that the greater the uncertainty regarding receipts and expenses, the greater the need for working capital

Approaches to working capital management

The trade-off between profitability and risk is an important consideration when formulating a working capital policy for a company. In other words, a company’s Net Working Capital (Current Assets – Current Liabilities) level has a bearing on both its profitability and risk. The term profitability here means profits after expenses.

The term risk is characterized as the possibility of a business becoming practically insolvent so that it cannot fulfil its obligations when they fall due for payment. It is believed that the higher the amount of Net Working Capital, the less risky the business is, and vice-versa. What proportion of current assets should be financed by short-term sources and how much by long-term financing will depend, apart from liquidity – profitability trade-off, on the risk perception of the management.

Working capital investment decisions are categorized into three approaches based on the organizational policy and risk-return trade-off, i.e., aggressive, conservative and hedging/moderate. Hedging approach is an ideal method of working capital financing with moderate risk and profitability. The other two approaches can be inferred to mean extreme level strategies.

Aggressive approach

The aggressive strategy is one of the approaches of working capital management wherein the company’s investments in working capital are kept at a minimum level, i.e., limited investment in current assets. This means that the entity holds lower inventory levels, follows strict credit policies, keeps less cash balance, etc.

Under this approach, current assets are maintained solely to just meet the current liabilities without cushioning for any variations in working capital requirements. The aggressive approach suggests that the entire estimated requirements of current assets or working capital should be financed from short-term funding sources. It says that even a part of fixed assets investments is to be financed from short-term sources.

The benefit of this strategy is that lower levels of funds are tied up with working capital, thereby leading to lower financial costs. However, the flip side might be that the organization may not grow, leading to less utilization of fixed assets and long-term debts. Over the long run, the firm could stay behind its competitors.

The aggressive strategy is extremely aggressive with very high risk and, thus, high profitability as a result. Some of the characteristics of the aggressive approach are as follows:

• Liquidity is low because of greater dependability on short-term funds even for a part of the long-term assets. It doesn’t hold idle funds and, thus, saves interest costs on them.

• Given that this approach minimizes the interest cost, higher profitability is achieved.

• Because of the extremely tight liquidity position being maintained, there is a high risk of bankruptcy.

• Too low level of current assets makes its utilization ratio (utilization of current assets) high.

• The working capital is kept very low. Low working capital raises risk but saves the cost of interest.

Conservative approach

Conservative strategy is one of the approaches of working capital management wherein the organization follows a strategy to invest a high amount of capital in current assets. Here, organizations are known to maintain a higher inventory level, follow liberal credit policies, and maintain cash balance as high as possible so that any existing liabilities can be met immediately.

A conservative strategy suggests that no risk is taken in the management of working capital and that high levels of current assets should be carried in relation to sales. Surplus current assets allow the company to handle unexpected fluctuations in revenue, manufacturing schedules, and procurement times without affecting the production plans. It requires maintaining a high level of working capital and should be funded through long-term funds, such as share capital or long-term debt.

The benefit of this strategy is higher sales volume, higher demand due to flexible credit policy being offered by the company, and increased goodwill among suppliers due to payment in a short span of time. The drawbacks are increased costs of capital, increased risk of bad debts, the possibility of liquidity shortages in the long-term, and longer operating cycles.

Conservative strategy is extremely conservative with very low risk and, thus, low profitability as a result. Some of the characteristics of the conservative approach are as follows:

• Liquidity is strong, as long-term funds are used heavily. It can reap the benefits of sudden opportunities.

• Because of too much idle and costly funds, profitability in this strategy is lower under normal circumstances. Higher interest rate and greater magnitude of cost reduce profitability.

• There is a very low chance of bankruptcy since this strategy retains a higher degree of liquidity in the company.

• Too high level of current assets makes its utilization ratio (utilization of current assets) low.

• Executing the conservatism policy needs more working capital. Higher working capital protects against all risks.

Moderate/Hedging or Matching approach

The moderate strategy is one of those approaches of working capital management which lies in between the above two approaches, i.e., aggressive and conservative approach. In this strategy, a balance between risk and return is maintained in order to benefit more by more effective use of the funds.

This approach classifies the requirements of total working capital into permanent and temporary. Permanent or fixed working capital is the minimum amount required to perform normal business operations, whereas temporary or seasonal working capital is required to satisfy specific requirements. Under this approach, the core/permanent working capital is financed from long-term capital sources, and short-term funding/borrowing is used to meet seasonal variations or temporary working capital needs.

Some of the characteristics of the moderative approach are as follows:

• Liquidity is equilibrated, i.e., neither high nor low. It seeks to strike a balance between liquidity and the cost of idle funds.

• A balance is reached between interest cost and loss of profitability due to cut-to-cut management. Here, moderate profitability is retained. It is more than that of the conservative approach and less than aggressive approach.

• The risk is equilibrated here. Only in an absolutely terrible situation would the company bow down to bankruptcy.

• The utilization of current assets is moderate.

• It maintains a moderate level of working capital to stay somewhere between conservative and aggressive strategies.

Takeaway