Question

What are some strategies that financial managers can follow in managing their working capital accounts? How does the concept of working capital trade-off affect these strategies?

Answer 1

Answer:

There are various strategies that financial managers can follow in managing their working capital. Here we will discuss the broad three ones:

1. Conservative Approach
2. Aggressive Approach
3. Matching Approach

These strategies are different from one another because of their trade off between risk and profitability.

Conservative Approach- As the name itself suggests, this approach is conservative i.e. does not believe in taking risk thereby results in lower profitability. This approach requires to maintain high level of current assets which is backed my funds like equity share capital or long term debt. Under this approach, there is adequate availability of working capital which allows the business operations to run smoothly without any delay in the production of goods or procurement of raw materials. Since this approach involves low risk, therefore, yield low returns.
Large amount of investments are made in current assets which will cause increase in interest and carrying costs but it will also allow continuous flow of operations in the business.
Long term financing covers majority of the working capital and any remaining part of temporary current assets is financed by short term funds so that in need, such short term funds are sold in the market to meet any emergency requirements.

Aggressive Approach- As the name suggests, under this approach, the current assets are maintained only to the extent of meeting the current liabilities. This approach reduces the investment in the working capital (current assets), thereby reducing the interest or carrying costs. This strategy involves frequent financing and increases the risk of the firm. It works on the principle of high risk, high profitability. Under this, long term funds are used to finance the fixed assets and a part of permanent current assets whereas to finance the temporary current assets and remaining part of permanent current assets, short term financing is used. It saves the interest cost at the cost of higher risk and thereby resulting in yielding higher returns.

Matching Approach- This strategy is also known as the hedging strategy. It runs on the principle of moderate risk and moderate profitability. It is somewhere a balance between aggressive and conservative approach. In this strategy, each asset of the balance sheet is financed by a debt instrument having same maturity period. For example, if an asset matures in 1 month then it will be financed by a debt which will also have its due date of payment after 30 days. It works on the principle that fixed assets and permanent part of current assets will be financed by long term funds whereas the temporary part of current assets will be financed by short term funds.

Thus, these three strategies are important strategies of working capital management. They differ on the terms of risk and profit. If plotted on a number line, conservative approach will be on the side of low risk and low profits. An aggressive approach will be on the side of high risk and high profits and the matching approach (also hedging approach) lies somewhere between the two.