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.
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 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.
Amongst the approaches of working capital management, an aggressive strategy is the riskiest. It does not presume to hold any funds in working capital to meet unexpected needs. Conversely, a conservative approach has the lowest risk and the lowest profitability among other working capital financing strategies. Hedging approach, which lies between the two, is based on the underlying principle that each asset should be financed with a financial instrument having almost the same maturity.
There are basically three approaches to financing working capital. These are: the Hedging approach, the Conservative approach and the Aggressive approach.What is working capital management and its capital management approaches? ›
Working capital management aims at more efficient use of a company's resources by monitoring and optimizing the use of current assets and liabilities. The goal is to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations and maximize profitability.What is working capital management in entrepreneurship? ›
Working capital management is essentially an accounting strategy with a focus on the maintenance of a sufficient balance between a company's current assets and liabilities. An effective working capital management system helps businesses not only cover their financial obligations but also boost their earnings.What are the approaches to the working capital financing mix? ›
The following points highlight the three approaches for determining the appropriate working capital financial mix, i.e., 1. The Hedging or Matching Approach 2. The Conservative Approach 3. The Aggressive Approach.What are the 3 approaches to working capital management? ›
Broadly, there are three working capital management strategies – conservative, hedging and aggressive. The effectiveness of these three approaches depends on risk and profitability.What are three financial approaches? ›
The net income approach, static trade-off theory, and the pecking order theory are three financial principles that help a company choose its capital structure. Each plays a role in the decision-making process depending on the type of capital structure the company wishes to achieve.What are the 4 main components of working capital? ›
A well-run firm manages its short-term debt and current and future operational expenses through its management of working capital, the components of which are inventories, accounts receivable, accounts payable, and cash.What is aggressive approach of working capital? ›
An aggressive working capital policy is one in which you try to squeeze by with a minimal investment in current assets coupled with an extensive use of short-term credit. Your goal is to put as much money to work as possible to decrease the time needed to produce products, turn over inventory or deliver services.What is hedging approach in working capital management? ›
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging requires one to pay money for the protection it provides, known as the premium.What is the main purpose of working capital management? ›
Working capital management represents the relationship between a firm's short-term assets and its short-term liabilities. It aims to ensure that a company can afford its day-to-day operating expenses while also investing the company's assets in the most successful direction possible.
- Enact contracts and/or Statement of Work templates and agreements. ...
- Use technology to prepare regular revenue recognition tasks. ...
- Make sure your employees complete timesheets every week. ...
- Streamline the invoicing process and payment deadlines. ...
- Focus on the project baseline.
Efficient working capital management helps ensure your business runs smoothly and includes managing your inventory, accounts receivables, and accounts payables. It also takes maintaining both your short-term assets and liabilities to ensure you have the liquid funds necessary to run your day-to-day operations.What is the modern approach of financial management? ›
The modern approach is an analytical way of looking into financial problems of the firm. According to this approach, the finance function covers both acquisition of funds as well as the allocation of funds to various uses.What is conservative approach and aggressive approach? ›
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.What are the types of working capital management? ›
- Permanent Working Capital.
- Regular Working Capital.
- Reserve Margin Working Capital.
- Variable Working Capital.
- Seasonal Variable Working Capital.
- Special Variable Working Capital.
- Gross Working Capital.
- Net Working Capital.
When budgeting, businesses of all kinds typically focus on three types of capital: working capital, equity capital, and debt capital.What are 3 example of working capital? ›
Cash, including money in bank accounts and undeposited checks from customers. Marketable securities, such as U.S. Treasury bills and money market funds. Short-term investments a company intends to sell within one year. Accounts receivable, minus any allowances for accounts that are unlikely to be paid.What are the sources of working capital management? ›
Sources of working capital
Long-term working capital sources include long-term loans, provision for depreciation, retained profits, debentures and share capital. Short-term working capital sources include dividend or tax provisions, cash credit, public deposits and others.
The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value. Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity.How many financial management approaches are there? ›
The scope of financial management is divided into two categories: Traditional Approach. Modern Approach.
- Forecasting Financial Require ments. It is the primary function of the Finance Manager. ...
- Acquiring Necessary Capital. ...
- Investment Decision. ...
- Cash Management. ...
- Interrelation with Other Departments.
- Gross working capital: This type of capital is the amount a company has invested in assets that can quickly convert to cash. ...
- Net working capital: The difference between current assets and current liabilities, net working capital can be positive or negative and shows a company's liquidity.
There are two concepts of working capital viz . quantitative and qualitative. Some people also define the two concepts as gross concept and net concept. According to quantitative concept, the amount of working capital refers to 'total of current assets'.What are the six basic components of working capital? ›
- Cash and cash equivalents.
- Accounts receivable (AR)
- Accounts payable (AP)
- Length of Operating Cycle: The amount of working capital directly depends upon the length of operating cycle. ...
- Nature of Business: ...
- Scale of Operation: ...
- Business Cycle Fluctuation:
As identified by most of the empirical studies, we have reviewed the following as the determinants of working capital management requirements: firm size, sales growth, profitability, leverage, level of economic activities, operating cycle and the nature of the business.