To accelerate the sales growth rate modifying the credit policy of a firm often leads to the desired result.
This relaxation has two results:
- Accounts receivable increase
- Sales volume increase
This also results in a positive effect on profitability and risk.
Sales volume can also be increased by increasing inventory. These various methods of financing influence the firm’s financial risk.
Characteristics of working capital:
Working capital comprises of cash, marketable securities, Accounts receivable, inventories and other assets. Working capital management deals with current assets and the ways in which they are financed.
- Short life: Working capital includes assets with a life span that is generally less than 1 years, such as, cash, market securities and accounts receivable as well as inventory. This short life span leads to high volatility in the level of investments required to finance working capital. Factors like materials shortages, strikes, energy curtailments etc. also affect volatility in levels of working capital.
- Nearness to cash: Working capital is also characterized by its “nearness to cash” or liquidity. The components of working capital generally possess liquidity and help against technical insolvency. The risk and return tradeoff are tempered by two additional considerations
- Nearness to cash or amount of time required to convert assets into cash
- Price realized on conversion.
- Lack of synchronization: The level of investments in working capital is affected by the sales volume, production policies and collection policies. And working capital management is affected by the lack of synchronization between components of working capital.
Financing Current Assets:
Working capital can be financed through equity or debt. How working capital is financed has a significant impact on the firms risk and return.
Matching of Asset Life and liability Maturity:
In this approach to working capital management, fixed assets are financed by permanent financing and assets by short-term liabilities.
Under match asset life and liability maturity and minimize risk and maximize returns. Under less than perfect conditions, asset life and liability maturity cannot be matched and the firm needs to consider other alternatives.
The Hedging Approach:
In the hedging approach permits the firm and current assets are financed with permanent capital and the fluctuating portion of current assets is financed with short term credit.
The hedging approach permits the firm to match its short term liability maturity with its fluctuating current asset financing requirements.
In the conservative approach. A firm finances all of its working capital needs through all of its working capital needs through permanent capital. For a financially conservative firm, the return is low and hence there is minimum risk.
In the aggressive approach, the firm finances a portion of permanent current assets through short-term borrowing. The profitability of the firm is increased since a relatively larger portion of its assets is financed through lower cost short-term borrowing. This leads to greater risk and higher returns.
Which Approach to Adopt:
A manager trying to manage his working capital as better as possible would have to look at the trade off between risk and return. If the desires greater safety , the larger the proportion of assets would be financed permanently. On the other hand, the desire for higher returns would call for greater utilization of short term financing.
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