The working capital policy of a company refers to the level of investment in current assets for attaining their targeted sales. In formulating a Firm’s Working Capital Policy, an important consideration is a trade-off (balance) between profitability and risk. In other words, the level of a firm’s Net Working Capital (Current Assets – Current Liabilities) has a bearing on its profitability as well as risk. The term profitability here means profits after expenses. The term risk is defined as the probability that a firm will become technically insolvent so that it will not be able to meet its obligations when they become due for payment.
The risk of becoming technically insolvent is measured using net working capital. It is assumed that the greater the amount of Net Working Capital, the less risky the firm is, and vice-versa. The relationship between liquidity, Net Working Capital, and risk is such that if either net working capital or liquidity increases, the firm’s risk decreases.
What proportion of current assets should be financed by current liabilities and how much by long term sources will depend, apart from liquidity – profitability trade-off, on the risk perception of the management. Two broad policy alternatives, in this respect, are:
- A conservative current Asset financing policy: It relies less on short term bank financing and more on long term sources. No doubt it reduces the risk that the firm will be unable to repay its short-term debt periodically, but enhances the cost of financing.
- An aggressive current Asset Financing Policy: It relies heavily on short term bank finance and seeks to reduce dependence on long term financing. It exposes the firm to a higher degree of risk but reduces the average cost of financing thereby resulting in higher profits.
To explain, an aggressive current asset policy aims at minimizing the investment in current assets corresponding to an increase in sales thereby exposing the firm to greater risk but as the result of higher expected profitability. On the other hand, the conservative policy aims at reducing the risk by having higher investment in current assets and thereby depressing the expected profitability. In between these two, lies a moderate current asset policy.
Current assets reflect the fund’s position of a company and are known as Gross Working Capital. Working Capital leverage is nothing but current assets leverage which refers to the asset turnover aspect of ROI. This reflects the company’s degree of efficiency in employing current assets. In other words, the ability of the company to guarantee a large volume of sales with a small current asset base is a measure of the company’s operating efficiency. This phenomenon is asset turnover which is a real tool in the hands of finance managers in a company to monitor the employment of funds on a cumulative basis to result in a high degree of working capital leverage.
Short-term loans or cash credit raised by the company to meet the requirements of working capital i.e. to finance the current assets, add to the profitability of the company’s turnover of current assets in comparison to the cost associated in terms of interest charges on such loans. This is the exact measure of working capital leverage. However, the concept of working capital leverage has not been much in use in academic discussions and its real importance is also to be understood by the business enterprises. To maximize profits, finance managers unanimously view the investment in current assets be kept to the minimum and should be financed from the funds such as current liabilities or low-cost funds.