The working capital policy is a function of two decisions, first, investment in working capital, and the second is the financing of the investment. Investment in working capital is concerned with the level of investment in the current assets. It gives the answer of ‘How much’ fund to be tied in to achieve the organization objectives (i.e. Effectiveness of fund). Financing decision concerned with the arrangement of funds to finance the working capital. It gives the answer ‘Where from’ fund to be sourced’ at the lowest cost as possible (i.e. Economy). Financing decision, we will discuss this in a later part of this chapter.
Investment of working capital
How much to be invested in current assets as working capital is a matter of policy decision by an entity. It has to be decided in the light of organizational objectives, trade policies, and financial (cost-benefit) considerations. There are no set rules for deciding the level of investment in working capital. Some organizations due to their peculiarity require more investment than others. For example, an infrastructure development company requires more investment in its working capital as there may be huge inventory in the form of work in process on the other hand a company that is engaged in the fast-food business, comparatively requires less investment. Hence, the level of investment depends on the various factors listed below:
- Nature of Industry: Construction companies, breweries, etc. require a large investment in working capital due to the long gestation period.
- Types of products: Consumer durable has a large inventory as compared to perishable products.
- Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory i.e. raw material, work-in-process, and finished goods whereas trading and a service entity have to maintain inventory only in the form of trading stock and consumables respectively.
- The volume of sales: Where the sales are high, there is a possibility of high receivables as well.
- Credit policy: An entity whose credit policy is liberal has not only a high level of receivables but requires more capital to fund raw material purchases.
Approaches of working capital investment
Based on the organizational policy and risk-return trade-off, working capital investment decisions are categorized into three approaches i.e. aggressive, conservative, and moderate.
- Aggressive: Here investment in working capital is kept at minimal investment in current assets which means the entity does hold a lower level of inventory, follows strict credit policy, keeps less cash balance, etc. The advantage of this approach is that a lower level of funds is tied to the working capital which results in lower financial costs but the flip side could be that the organization could not grow which leads to lower utilization of fixed assets and long-term debts. In the long run, firms stay behind the competitors.
- Conservative: In this approach of organizations use to invest high capital in current assets. Organizations use to keep inventory level higher, follow liberal credit policies, and cash balance as high as to meet any current liabilities immediately. The advantage of this approach is higher sales volume, increased demand due to liberal credit policy, and increase goodwill among the suppliers due to payment in a short time. The disadvantages are increase cost of capital, higher risk of bad debts, shortage of liquidity in long run to longer operating cycles.
- Moderate: This approach is in between the above two approaches. Under this approach, a balance between the risk and return is maintained to gain more by using the funds in a very efficient manner.