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What are the 3 Working Capital Financing Policies?
A business firm may choose to go with long-term, short-term, or a mix of the two to finance its operations.
Depending on the mix of short- and long-term approaches, three types of working capital policies may be found which are as follows −
When the expected life of assets is matched with the expected life of the source of funds, the approach is known as the matching approach. In this approach, short-term financing is used for short-term assets while long-term financing is used for long-term assets.
The justification for such an approach is that since financing is meant for paying the assets, the assets and the financing should be relinquished simultaneously.
Using long-term financing for short-term assets would lead to less utilization of funds, whereas short-term financing for long-term assets would create a void of funds. Therefore, the assets and financing patterns are matched in this approach to get the maximum benefits from the working capital financing policy.
When a company follows the matching approach, long-term financing will be utilized to finance fixed assets or permanent current assets, whereas short-term financing will be used for variable or temporary current assets.
In a conservative approach, a firm relies mostly on long-term funds for the firm’s financing needs.
The justification for choosing a conservative approach is that with long-term financing, the company would not fall in trouble even if it needs short-term funds as the long-term fund will cover short-term needs as well. In the case when the company does not need temporary or current assets, idle, long-term funds may be invested in securities.
As is obvious, in the case of a conservative approach, the company finances its fixed assets and a part of its temporary assets with long-term financing. The idea is to avoid a shortage of funds even when the business does not need temporary assets financing.
The idea of investing the funds in tradeable securities when there is no need of funding the temporary assets arises from the fact that investing in tradeable securities would offer the return needed to fulfil the void that would arise if the funds are kept idle and tied up in the company’s operations.
Therefore, the conservative approach is a moderate approach that does not take any risk of shortage of funds during the process of operations of a business. The downside of the conservative approach is that the returns obtained from this approach may not be as high as other approaches that are utilized to finance the working capital.
A company is said to follow an aggressive working capital financing policy if it finances most of its temporary assets with short-term financing in a proportion that is beyond the matching approach. A portion of the permanent current assets is financed by short-term financing in the case of an aggressive approach.
In some instances of an extremely aggressive approach, some companies may even finance some portion of permanent assets with short-term financing tools. The returns obtained via the aggressive approach are higher than all other approaches but the risk is also higher in this case.
It is the particular requirement and nature of the business that must be considered while selecting a particular working capital financing policy. Each approach has its upside and downside but the companies must be careful not to choose the wrong approach which can destabilize the business operations.
The matching approach is great for businesses that do not want to take too much or too less risk while the conservative approach is for the companies that want to take relatively fewer risks. The aggressive approach, on the other hand, is for the companies that want to seek higher returns by taking relatively higher risks than most other companies.
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