Working Capital Management PART 4 | Investing Policies| Financing Policies

WORKING CAPITAL POLICIES
•Can be explained in INVESTING or FINANCING terms.
•Both working capital investment and financing policies use the terms:
Conservative
Moderate
Aggressive

Working capital investment policy
• This is concerned with the level of investment in current assets, with one company being compared with another.
• The investment policy is therefore assessed on an inter-company comparative basis.
 An aggressive approach is when one company hasa lower level of investment in current assets compared to another company.
 A conservative approach is when one company has a higher level of investment in current assets compared to another.
 A moderate approach is when one company has a comparable level of investment in current assets compared to another.

Working capital financing policy
• This is concerned with the relative proportions of short-term and long-term finance used by a company.
• The assessment involves analysis of financial information for one company alone.
• Working capital financing policy uses an analysis of current assets into:
 Permanent current assets
 Fluctuating current assets

Permanent current assets represent the core level of investment in current assets that supports a given level of business activity.
Fluctuating current assets represent the changes in the level of current assets that arise through, for example, the unpredictability of business operations, such as the rise of the level of trade receivables due to some customers paying late.

• Working capital financing policy relies on the matching principle.
• The matching principle holds that long-term assets should be financed from a long-term source of finance.
 Non-current assets and permanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance.
 Fluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan.
• In working capital financing policy, we look at the way in which fluctuating current assets and permanent current assets are matched to short-term and long-term finance sources.
 An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed from a short-term finance source.
An aggressive financing policy will be more profitable although much riskier.
It is more risky because short-term finance is riskier than long-term finance than long-term finance.
For example, an overdraft is repayable on demand.

 A conservative financing policy means that permanent current assets and a portion of fluctuating current assets are financed from a long-term source.
It is less profitable because long-term finance is expensive than short-term finance.
 A moderate financing policy (aka matching policy) means that fluctuating current assets are financed by short-term sources and permanent current assets are financed by long-term sources.

NOTE:
The two policies are very different in terms of their meaning and application.
It is possible for a company to have a conservative working capital investment policy while following an aggressive working capital financing policy.