“Short term financial strategy, what is working capital and how to finance working capital”
In this chapter, we are going to discuss “short term financial strategy” , “what is working capital” and “how to finance working capital”.
What is short term strategy ?
Any company needs liquid resources to finance its working capital requirement. The short-term financial strategy involves planning to ensure enough day to day cash flow and is determined by the management of working capital.Above all, this involves achieving a balance between lower the risk of insolvency and maximize profits.
What is working capital ? / How to find working capital ?
Working capital calculates using the following formula. This represents short term finance requirements for day to day operations of the company.
Working Capital = Current Assets – Current Liabilities
As a finance manager, you should pay attention to the working capital policy. The working capital policy consists of investment decisions and financing decisions. Also, Working capital in an organization has to be funded, and working capital investment can be a significant drain on resources that a company has.
Working capital management
There are three types of working capital policies in corporate finance.
- Aggressive working capital management
- Moderate working capital management
- Conservative working capital management
Aggressive working capital policy
This policy aims to reduce the finance cost and increase profitability.
Pros of aggressive working capital policy
- Cutting inventories
- Speeding up collections from customers
- Delaying payments to suppliers
Cons of aggressive working capital policy
- System breakdown
- Loss of goodwill
Conservative working capital policy
This policy aims to hold high working capital to reduce the risk of system breakdowns.
Pros of conservative working capital policy
- Generous payment terms to customers.
- High finish goods in the stocks.
- Raw materials and work in progress are high to minimize the risk of running out of inventory.
- Paying the suppliers as may fall due.
Cons of conservative working capital policy
- Unproductive assets.
- High finance costs resulting in lower profitability.
Moderate working capital policy
This policy aims to have a balance between profitability and liquidity of the firm.
Working capital finance
There are different ways in which the funding of the current and non-current assets of a business. Financing can be achieved by using sources of long and short term financing. However, short-term financing is usually cheaper than long-term financing.
Further, permanent current assets together with fluctuating current assets form part of the working capital of the business. This may be financed by either long-term funding or by current liabilities.
Conservative financing approach
All non-current assets and permanent current assets, as well as part or even all of the fluctuating current assets, are financed by long-term funding. Above all, there will be excess cash; the company will be able to invest in securities.
Aggressive financing approach
In this approach, not only fluctuating current assets but also part of the permanent current asset are financed through short term funding sources. This policy represents an increased risk of liquidity and cash flow problems.
Moderate financing approach
In this method, balance of risk and return can be achieved.
