Management of working capital is one aspects of financial management that can either make or mare the fortune of a company. A profitable company can easily go underground if the liquidity position of the company is not viable enough to withstand temporary cash shock. The management of working capital financing is so important that many Institutions of higher learning have made the study of working capital management a large chunk of their financial management module.
Working capital management or what many call ‘current assets financing’ needs to be optimal so as not to harm a business both from profitability perspective and liquidity perspective. Company lose out of profits that would be earned by investing cash in projects with non-zero NPVs when the cash is tied town in working capital or in financing current assets. In like manner, creditors might initiate bankruptcy procedure against a company if the company cannot meet its short to medium term obligations.
The problem that many managers encounter while trying to strike a balance between profitability and liquidity as far as their current assets financing is concerned is to identify what needs to be considered in order to achieve a fairly right level of financing of working capital that will help achieve a company’s objectives both financial and non financial objectives.
The aim of this article is to identify and briefly discuss those that factors that every financial manager must consider while seeking optimal level of current assets financing. Before we delve fully into discussing the factors that affects current assets financing, let’s quickly look at the psychology of formulating working capital policy. Yes, you read it that right.
There are basically three working capital policy formulation school of thoughts which a company can choose to follow, depending on the strategic plan of a company. Theorists in working capital management have been able to come up with idea of identifying two parts of working capital; the fixed element and the fluctuating elements of WC.
- Aggressive school of thought: these are group of companies that finances all fixed portion of WC and sizeable portion of working capital with short-term funds. This is considered by many to be a very risky but profitable approach.
- Matching school of thought: here, practitioners match tenure of funds with the nature of assets that the fund will finance. The only problem here is the ability of the management to clearly distinguish fixed from fluctuating working capital.
- Conservative school of thought: under this school of thought, the ideal way of financing investments in working capital is to finance all fixed portion of WC with long-term finance and then a reasonable portion of the fluctuating WC with long-term fund. This is prudent way of managing the liquidity position of a business but might be at the expense of profitability.
In practice, no company practices 100% of any of the above approach, companies continually strives to strike a balance that will make most of the prevailing situation.
10 DETERMINANTS OF CURRENT ASSETS FINANCING
- Nature of business
- Overall economic condition
- Company policy
- Risk attitude of managers
- Level of competition in industry
- Government policies and legislation
- Terms of trade
- Size of a company
- Customer database of a company
- Length of working capital
Most finance professionals will agree with me that the above list is not exhaustive, but they are the fundamental checks that need to be done before committing to determining the working capital level of a business.
Irrespective of the philosophy of management regarding formulating the working capital policy of a company, the factors that have been identified in this article must be carefully considered while tweaking to find the optimal working capital financing requirement of a business. For example, receivables and accounts payables management efforts will boil down to nothing if the above factors are not taken into consideration.