What Are The 3 Working Capital Financing Policies?

Every business, irrespective of size, needs to manage working capital effectively. In fact, it has been seen in the Association of Chartered Certified Accountants (ACCA) 2023 report that 57% of businesses face cash flow problems due to poorly managed working capital. Many businesses struggle between holding a good amount of money to run day-to-day expenses and using some to create long-term growth opportunities. In that regard, working capital finance plays an important role.

A company needs to choose a suitable working capital financing policy so that they neither end up with inadequate liquidity nor overburden themselves with debt. We herein discuss the three major policies of working capital financing: conservative, aggressive, and matching.

1. Conservative Working Capital Financing Policy: Prioritising Safety Over Risk

A conservative working capital financing policy will therefore have a very high liquidity level. This is a practice that retains much more in current assets, such as cash and inventory, in comparison to current liabilities, which are short-term debts. It aims at having enough funds with which all obligations by the firm can be honoured without risking financial distress.

Such policies usually utilise long-term financing by the companies, which may include long-term loans or equity to finance not only fixed assets but also some working capital. Consequently, even during low sales or economic adversity, the company can rely on their accumulated reserves.

Advantages of Conservative Policy:

• Reduced Risk: By maintaining a high level of liquidity, companies are less likely to face cash flow shortages.
• Financial Stability: A cushion of liquid assets ensures that businesses can handle unexpected expenses or drops in revenue.
• Lower Borrowing Costs: Relying more on long-term financing can often result in lower borrowing costs, as long-term loans generally have lower interest rates than short-term ones.

Disadvantages of Conservative Policy:

• Lower Returns: Excess liquidity can lead to lower returns on investment, as funds that could be used for growth are tied up in low-yielding assets.
• Opportunity Cost: Keeping too much cash on hand may mean missed opportunities for investment in more profitable ventures.

For conservative firms that fear risk and prefer stability, a conservative policy is suitable. This approach is, however, not advisable for companies interested in high growth rates due to the limitation of expansible funds.

2. Aggressive Working Capital Financing Policy: Maximising Profit with Higher Risk

The aggressive working capital financing policy is the reverse of the conservative approach. In this case, companies try to invest as little as possible in current assets. This is accomplished by making use of short-term financing to take care of both transitory as well as a few permanent working capital needs.

Companies hold much lesser levels of cash and inventory through this policy and instead utilise short-term loans, trade credit, and other short-term liabilities to acquire enough working capital. The objective of the working capital policy is to minimise the carrying cost of excess assets thus raising profitability.

Advantages of Aggressive Policy:

• Higher Returns: By investing less in current assets and more in revenue-generating activities, companies can achieve higher returns on investment.
• Efficient Use of Capital: This policy allows businesses to allocate more funds to strategic investments, such as product development or market expansion.

Disadvantages of Aggressive Policy:

• Increased Risk: Relying heavily on short-term financing can lead to liquidity issues, especially if the company faces unexpected expenses or a decline in revenue.
• Interest Rate Sensitivity: Short-term loans often come with variable interest rates, making the company vulnerable to interest rate fluctuations.
• Potential Insolvency: In worst-case scenarios, an inability to meet short-term obligations could lead to insolvency.

Growth industries and companies seeking to seize short-term opportunities would be appropriate for aggressive working capital financing policies. But this does require proper management and a higher risk level to be acceptable.

3. Matching (or Hedging) Working Capital Financing Policy: Balancing Risk and Return

The matching, or hedging, working capital financing policy is essentially a compromise between a conservative and an aggressive approach. This essentially involves financing assets with liabilities that have analogous maturity periods. In short, short-term assets are financed with short-term liabilities, and long-term assets are financed with long-term liabilities.

For example, a business can source short-term loans or trade credit for its inventories and accounts receivable while long-term loans or equity is used for funding the company’s fixed assets-which incorporate machinery and buildings. The model is based on matching inflows of cash and outflows of cash over time and at the same time minimises risk.

Advantages of Matching Policy:

• Risk Management: By aligning the maturities of assets and liabilities, companies can reduce the risk of cash flow mismatches.
• Optimal Use of Funds: This policy allows for an efficient allocation of resources, ensuring that funds are available when needed without tying up capital unnecessarily.
• Flexibility: The matching policy provides a balanced approach, offering a moderate level of liquidity and risk.

Disadvantages of Matching Policy:

• Complex Management: Managing a matching policy requires careful planning and forecasting to align asset and liability maturities effectively.
• Moderate Risk: While this policy reduces risk compared to an aggressive approach, it still exposes the company to some level of financial risk.

A matching working capital financing policy is appropriate for firms seeking something in the middle. The risk-return balance achieved by such a policy allows companies to maintain liquidity without missing investment opportunities. Hence, numerous firms opt for this type of financing.

How to Choose the Right Working Capital Financing Policy for Your Business

The choice of working capital financing policy is also dependent on many factors, such as the nature of your business and industry and your perceived risk tolerance. Some important things to consider:

• Business Stability: If your business operates in a stable industry with predictable cash flows, an aggressive policy might be suitable. Conversely, if you operate in a volatile market, a conservative approach may be more prudent.
• Growth Objectives: For companies focused on rapid growth, an aggressive policy can provide the necessary funds for expansion. However, this comes with higher risk.
• Risk Tolerance: Assess your company’s ability to handle financial risk. A conservative policy is suitable for risk-averse businesses, while a matching policy offers a balanced risk-reward ratio.
• Cash Flow Needs: Consider your short-term and long-term cash flow requirements. The matching policy can help align these needs effectively.

Conclusion Words: Finding the Right Balance for Your Business

Working capital financing is a critical component in a company’s overall financial health and operational efficiency. Of the three, conservative, aggressive, and matching policies are each distinct from one another in terms of advantages and disadvantages. What might work best for your business hinges on your specific situation. If you value safety more, wish for higher returns, or seek a well-balanced approach, an understanding of these policies helps to optimise your working capital.

KredX comes up with innovative finance options tailor-made to suit varied demands for companies looking to streamline their funding for working capital. Talk to the experts at KredX to know how we can help you to achieve financial freedom and efficiency.