Working capital strategies and financing

Section overview

• Organisations have to decide what are the most important risks relating to working capital, and therefore whether to adopt a conservative, aggressive or moderate approach.

• Working capital can be funded by a mixture of short and long-term funding.

LO 8.1

4.1 Approaches to working capital management

Organisations have to decide what are the most important risks relating to working capital, and therefore whether to adopt a conservative, aggressive or moderate approach.

4.1.1 A conservative approach

A conservative working capital management policy aims to reduce the risk of system breakdown by holding high levels of working capital.

Customers are allowed generous payment terms to stimulate demand, finished goods inventories are high to ensure availability for customers, and raw materials and work in progress are high to minimise the risk of running out of inventory and consequent downtime in the manufacturing process. Suppliers are paid

promptly to ensure their goodwill, again to minimise the chance of stock-outs.

The cumulative effect on these policies can be that the firm carries a high burden of unproductive assets, resulting in a financing cost that can destroy profitability. A period of rapid expansion may also cause severe cash flow problems as working capital requirements outstrip available finance. Further problems may arise from inventory obsolescence and lack of flexibility to customer demands.

4.1.2 An aggressive approach

An aggressive working capital management policy aims to reduce this financing cost and increase profitability by cutting inventories, speeding up collections from customers, and delaying payments to suppliers.

The potential disadvantage of this policy is an increase in the chances of system breakdown through running out of inventory or loss of goodwill with customers and suppliers.

However, modern manufacturing techniques encourage inventory and work in progress reductions through just-in-time policies, flexible production facilities and improved quality management. Improved customer satisfaction through quality and effective response to customer demand can also mean that credit periods are shortened.

4.1.3 A moderate approach

A moderate working capital management policy is a middle way between the aggressive and conservative approaches.

4.2 Permanent and fluctuating current assets

In order to understand working capital financing decisions, assets can be divided into three different types:

(a) Non-current (fixed) assets are long-term assets from which an organisation expects to derive benefit over a number of periods. Buildings or machinery are examples.

(b) Permanent current assets are the amount required to meet long-term minimum needs and sustain normal trading activity, for example, inventory and the average level of accounts receivable.

(c) Fluctuating current assets are the current assets which vary according to normal business activity. This may be due to seasonal variations.

Fluctuating current assets together with permanent current assets form part of the working capital of the business, which may be financed by either long-term funding (including equity capital) or by current liabilities (short-term funding).

4.3 Working capital financing

The funding of the current and non-current assets of a business can be achieved by employing different combinations of long and short-term sources of funding.

Short-term sources of funding are usually cheaper and more flexible than long-term ones. However short-term sources are riskier for the borrower as interest rates are more volatile in the short short-term and they may not be renewed.

LO 8.1

The diagram below illustrates three alternative types of policy A, B and C. The dotted lines A, B and C are the cut-off levels between short-term and long-term funding for each of the policies A, B and C

respectively: assets above the relevant dotted line are financed by short-term funding while assets below the dotted line are financed by long-term funding.

(a) Policy A can be characterised as a conservative approach to financing working capital. All non-current assets and permanent non-current assets, as well as part of the fluctuating non-current assets, are financed by long-term funding. There is only a need to call upon short-term financing at times when fluctuations in current assets push total assets above the level of dotted line A. At times when fluctuating current assets are low and total assets fall below line A, there will be surplus cash which the company will be able to invest in marketable securities.

(b) Policy B is a more aggressive approach to financing working capital. Not only are fluctuating current assets all financed out of short-term sources, but so are some of the permanent current assets. This policy represents an increased risk of liquidity and cash flow problems, although potential returns will be increased if short-term financing can be obtained more cheaply than long-term finance.

(c) A balance between risk and return might be best achieved by the moderate approach of policy C, a policy of maturity matching where the length of the finance is matched to the life of the asset so that long-term funds finance permanent assets while short-term funds finance non-permanent assets.

4.4 Other factors

The overall approach to working capital management will be complicated by the following factors:

(a) Industry norms

These are of particular importance for the management of receivables. It will be difficult to offer a much shorter payment period than competitors.

(b) Products

The production process, and hence the amount of work in progress is obviously much greater for some products and in some industries. For example the production period for an aircraft

manufacturer will be significantly longer than that of a company which produces children’s clothing.

(iii) Management attitudes to risk.

(iv) Previous funding decisions.