Introduction
Working capital management relates to strategies of managerial accounting that companies adopt to help in the monitoring and utilization of the two components used in calculating working capital, current liabilities and current assets, to ensure that the companies function effectively. The most fundamental objective of adopting working capital management is to make sure that companies have smooth operating cycles in their businesses (Balestra, 2017). In addition, such strategies help in in the optimization of the levels of working capital as well as the minimization of the costs related to such funds. These objectives resonate with the main objective of financial management, which to maximize wealth generation for the company, which is attainable through the maximization of profits that is then accompanied by the firms’ sustainability in growth and development. There are different strategies of working capital management, which this paper reports. As the paper reports, the variations in the methods of such management occur because of their variations in their treatments of trade-offs between profitability and risk as well as extent of their usage of short and long-term fund to financing working capital.
The Concepts of Short and Long-Term Financing and the Standpoints of Risk and Profitability
Before proceeding to discuss the different strategies used in the management of working capital, it is needful to understand the concepts of short and long-term financing in relation to profitability and risk tradeoff as mentioned in the introduction. First, while considering the profitability standpoint, it should be noted that short-term rates of interest are cheaper than long-term ones since the period of the premium is short (Michalski, 2014). This factor implies that short-term rates have lower costs of interest and higher levels of profitability compared to long-term interests that have lower profitability at higher interest costs. Therefore, it should, be understood that using long-term funds in financing working capital results in the payment of unnecessary interest for periods during which such funds are not being used (Michalski, 2014). Short-term financing comes out as the better option for firms that want to gain profits on their financing.
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However, while considering the risk standpoint in working capital financing, there is a need to understand that there exist two types of risk in short-term financing. The first such risk is that of interest and the second is that of refinancing (Michalski, 2014). In addition, there is a need to understand that the rates of refinancing keep fluctuating with economic circumstances and that it is so uncertain that the lender may deny it. In such a case, the organization seeking to refinance may be compelled to sell off their business assets or to file for liquidations in the event that their assets are not able to meet the financial value required for the refinancing (Preve and Sarria-Allende, 2010). It implies, therefore, that the risk of adverse changes in the rates of interest during the refinancing process may raise the cost of such financing, which may then translate to low profitability of the involved companies. Nevertheless, literature reports that long-term financing does not have both the risk of interest fluctuation and that of financing, which means that they are useful when companies want to reduce the risk of financing their working capitals.
The Strategies of Working Capital Management
Having understood the concepts concerning long and short-term financing for working capital, it is useful to discuss what extant literature reports concerning the approaches of management of working capital. There are three strategies used in the management of working capital, hedging, aggressive, and conservative (Bhattacharya, 2014). The graph in figure 1 below and the accompanying equations are useful in explaining the differences and relationships among the three approaches of working capital management. However, there is a need to clearly understand the graph and the variables it contains. First, the red lines on the graph are a representative of the three strategies of working capital management. Of the three red lines, the simple one represents the conservative strategy, the middle one for the hedging strategy while the dotted one represents the aggressive strategy. There is also a need to understand that the lines are used to represent the levels to which long-term resources are used in financing working capital. It should also be noted that the higher the line, the larger the investment through long-term financing methods.
Figure 1 : the three strategies of managing working capital using long-term methods of financing. Adapted from Deloof (2003).
The following abbreviations will be used in the formulas in calculations using each strategy of working capital management:
TWC: Temporary Working Capital
PWC: Permanent Working Capital, and
FA: Fixed Assets
The hedging strategy, also called the maturity matching approach, refers to a meticulous methods used in financing working capital that have moderate levels of profitability and risk (Bhattacharya, 2014). While using this approach, it is needful to consider that all the assets will be financed using instruments of debt of almost similar maturity. By this statement, it means that, for example, if the asset used in the financing of the debt has a maturity period of sixty days, the payment of such financing debt will have a due date same as the sixty days or slightly over (Bhattacharya, 2014). The cardinal principle of financing underpins this type of working capital financing and management. According to support literature such as Preve and Sarria-Allende, (2010), the cardinal principle depends on the usage of long-term sources in the financing of long-term assets. This means that the principle directs that the fixed assets of a company and temporary working capital as well as a section of its permanent working capital are financed using the methods of financing in the short-term (Michalski, 2014). In this strategy, the funds are applicable using the following formula and are represented in figure 1 above:
The long-term funds will be used in funding the FA + PWC, while
The short-term funds will be used in financing the TWC
The conservative approach to the management of working capital draws its name from the desire by many companies to reduce the risk of financing (Preve and Sarria-Allende, 2010) In such circumstances, the companies are willing to have low levels of profitability as long as they do not risk failing to refinance their debts. Consequently, the conservative strategy is utilized by firms that desire to operate without risking eh smoothness of their operations through avoiding high risks on their working capital financing. In this approach, a section of the temporary working capital, permanent current assets, and fixed assets are financed using the long-term sources of financing the operations of the company. This approach is associated with the lowest levels of liquidity risk at higher interest outlay costs. Figure 1 above and the formula below can be used in indicating how the conservative approach to working capital management is applied:
The long-term sources of finance will be used in funding the FA + PWC + portions of the TWC, while
The remaining portion of the TWC will finance the short-term sources of working capital financing
According to Hill (2013), the aggressive strategy implies what its name means in literary terms. The later cited study indicates that the fundamental objective of this strategy is on the levels of profitability of the activities of a company involving the working capital. This means, therefore, that the aggressive strategy is a high-risk, high-profitability approach to working capital financing. Managers that may opt for this strategy do so only for the purposes of financing the fixed assets of a company as wells a portion of the permanent working capital of a company. Therefore, it implies that the rest of the assets, the rest of the temporary working capital as well as portions of the permanent working capital will be offset by the short-term sources of funding available to a firm. This approach is desirable for most companies for the fact that it helps in saving the costs of interest at the costs of high risk. Figure 1 above and the formulas below are used in indicating how the sources of working capital financing are used under the aggressive strategy:
Long-term sources of working capital financing will be used in funding the FA + a portion of the PWC, while
The short-term sources of working capital financing will be used in the funding of the remainder of PWC + TWC
The descriptions of the strategies of working capital management in this section, therefore point at the fact that they differ according to their treatment of risk and the desire for profitability. As such, if the three strategies were to be plotted on a number line that will have low risk and low profitability on one side and high profitability and high risk on the other, the aggressive strategy would appear on the later side while the conservative strategy would be on the opposite end. In addition, the hedging strategy would be in between the two strategies. It should also be noted that the hedging strategy is not quite practical in the real world because it is not easy to find organizations that have similar attitudes to risk and profitability as described by the ideals that the model postulates (Hill, 2013). Overall, the findings of this paper emphasize the usefulness of financial management in steering firms and businesses to profitability.
Conclusion
This paper has argued for the importance of financial management in the profitability of a company. Specifically, it has been demonstrated that working capital management strategies may prove useful for such organizations in their quest of attaining profitability and ensuring a smooth flow of their business activities. The three strategies used in the management of working capital hold different views of profitability and risk. For example, while the conservative approach takes the approach of low risk and low profitability, aggressive one opts for high risk and risk profitability as the hedging approach remains in the middle. It means, therefore, that the choice of the strategies would be reliant on the perception of risk of managers. The paper has also reported that the hedging strategy may be applicable in the real world of business since its ideals do not consider characteristics of the corporate world. Overall, the work has demonstrated the usefulness of financial ratios in strategy formulation of companies, indicating the connection between theory and practice in financial management.
References
Balestra, D. (2017). Working Capital Management Strategies for Today . CFO . Retrieved 17 September 2017, from http://ww2.cfo.com/accounting-tax/2015/06/five-working-capital-management-strategies/
Bhattacharya, H. (2014). Working capital management: Strategies and techniques . PHI Learning Pvt. Ltd..
Block, S. B., Hirt, G. A., & Short, J. D. (1992). Foundations of financial management . Irwin.
Deloof, M. (2003). Does working capital management affect profitability of Belgian firms?. Journal of business finance & accounting , 30 (3‐4), 573-588.
Hill, R. A. (2013). Working capital management. Recuperado de http://202.191 , 120 , 8020.
Michalski, G. (2014). Value-Based Working Capital Management: Determining Liquid Asset Levels in Entrepreneurial Environments . Springer.
Preve, L., & Sarria-Allende, V. (2010). Working capital management . Oxford University Press.
