The management of working capital is an essential activity for running a business in the contemporary world. The working capital determines the ability of a company to settle short-term debts and fund the running operations. Working capital refers to the amount of money available to cover the cost of transactions and short-term obligations. Working capital management refers to making decisions that are related to financial control (Graham and Smart 303). It also refers to making decisions on short-term financing to ensure that the business is in a good position to cover the operational expenses and make a profit. The strength of working capital is determined by the difference between the current assets and current liabilities.
Working Capital Policies
For a business to mitigate the risks of incurring deficient working capital, it is essential to have feasible policies. The management of working capital facilitates organizational growth. Consequently, it should be done by professionals in the case of large enterprises that spend a considerable amount of money on operations. In large companies, there is a high risk of decision-makers swaying some money to their interest. As a result, the managers should ensure that there are policies to govern the management of working capital.
Also, businesses are often involved in numerous investment ventures. Hence, policies should be put in place to govern how the level of investments in working capital is carried out. Furthermore, there is a need to determine to what extent the bank overdrafts should finance the working capital among other ways of short-term financing. Such a strategy ensures that the business has sufficient measures to mitigate the financial risks that would occur if a lot of funds are used to finance the working capital. The approach helps when the business is in an incapacitated financial position (Graham and Smart 303).
A business should have policies that govern the management of inventories, trade receivables, cash at hand, and short-term investments. The systems mitigate possible risks of decision-making procedures that are intended to benefit personal interests (Delimatsis 76). For instance, a manager may propose the issuance of credit to customers with low credit ratings because of contact with the client. In such a case, there should be policies that define the level of creditworthiness of a customer and the business relations for the credit to be allowed. There are instances when a company has unnecessary inventories, which sets back the working capital. Therefore, working capital policies should govern the level of stocks and current assets at any given time (Delimatsis 78). They should also act as the guiding principle in determining the need for short-term financing and the method that is most favorable to the business. Sensible policies will help the company to have a working capital that is within its requirements. The policies should depend on the nature and size of the enterprise.
The policies should define the levels of working capital that a business should incorporate into its operations. It can help to control profitability since a massive amount of working capital depicts that less amount is allocated to investments and other activities that have positive returns to the business. The three primary types of working capital policies include aggressive, conservative, and moderate. The aggressive policy ensures that a company allocates less cash to current assets. The company operates low levels of inventory, trade receivables, and cash for a specified degree of activity and sales. The greatest risk that faces a business under the aggressive policy is running out of stock and the inability to cover the cost of operations due to a shortage of cash (Delimatsis 81).
The conservative policy enables a business to have a flexible working capital strategy. The amount of working capital varies depending on the value of expenses and costs to be incurred. The greatest risk that is associated with the conservative policy is the inability to make enormous profits since a large amount of money is held up as the working capital. The moderate policy “lies between the aggressive and the conservative policies” (Delimatsis 81). A business aims at having low working capital that is flexible.
Whenever a company incurs a shortage of working capital, it looks for short-term financing methods to cover the deficit. The methods of short-term financing include bank overdraft, trade credit, bank loans, banker acceptance, commercial paper, leasing, and factoring. However, the decision to undertake any of these methods is solely determined by various factors like capital management policies (Pride, Hughes, and Kapoor 59).
When a business faces financial challenges as a result of the expenses exceeding the balance of the current account, the company may seek financial assistance from the bank. Bank overdraft is the most common method of short-term financing used by businesses because banks are willing to finance their customers rather quickly than in the case of other methods (Sagner 26). However, the amount to be overdrawn is regularly adjusted depending on the amount borrowed at any given time. There is a limit that an overdraft cannot exceed. Banks are solemn at mitigating credit risks. Therefore, they do not entertain customers who have a habit of borrowing regularly. The repayment of overdrafts is dependent on the demand, and its security is attached to the fixed assets.
However, various factors must be considered to determine whether a business should apply for an overdraft. First, the cause of the deficit is assessed to verify whether it is worthy for a company to seek overdrafts. The needs for an overdraft are evaluated to determine whether they are attached to current assets or liabilities (Sagner 27). If the reason for the deficit is a result of increased current liabilities, it shows that the business is in an unhealthy financial position. Thus, short-term financing may not be a useful solution. However, if the deficit is a result of increased inventories or other current assets, the overdraft can be sought as a short-term solution. The company can meet the deficit after selling goods (Sagner 30).
Second, the duration that a firm is expected to take before meeting the deficit is considered to assess if an enterprise will be able to cover the overdraft within a short period. For instance, if the company incurred debt as a result of the acquisition of huge inventories, there is a high probability of meeting the deficit within a short period (Siddaiah 239). Therefore, an overdraft can be an effective method of short-term financing. On the other hand, if the deficit resulted from losses or increased liabilities, the business should go for long-term financing methods. It would take a long time to establish the causes of such problems and develop lasting solutions.
Third, the amount that is required to cover the deficit determines the method of financing that suits a business. Banks set the limit to the amount that can be overdrawn from the enterprise’s account. Hence, if the deficit exceeds the limit, the bank may advise a business person to take a short-term loan (Siddaiah 237). However, the investor should decide on a favorable method of financing since there are other alternatives to overdraft. Fourth, banks charge interest on overdrafts. The rate of benefits varies according to the amount overdrawn. Hence, business managers should evaluate the interest rate that a bank charges to determine whether it is better to take loans as opposed to overdrafts. There are situations where interest may be high prompting the businessperson to take a loan (Siddaiah 239).
Acquisition of goods and services on credit seems like a normal way of doing business. Trade credit is the most utilized method of raising capital for an enterprise. However, companies use it as a short-term financing option since the creditor is also a commercial entity. The creditor has to be paid within a short period. The decision to acquire goods and services on credit is usually reached after analyzing the financial position of the business. Businesspersons take goods on credit after realizing that the company is capable of settling the short-term credit within a short period (Siddaiah 241). The company extending the credit must also operate under the working capital management policies that require it to analyze the creditworthiness of the customers.
Banks are the most common financiers to businesses. Indeed, bank loans are the most accessible source of finance whenever companies suffer from financial deficits. Banks offer two forms of loans. They are short-term and long-term loans. Short-term loans are issued with a condition that they are repaid in a period that does not exceed twelve months. Therefore, businesses take short-term loans for interim financing purposes, particularly when the current liabilities exceed the current assets.
Banker acceptance is an agreement of responsibility by a bank where it guarantees a future payment (Siddaiah 242). The business can sell the contract to a third party as a deposit. The party has to wait for the maturity of funds as specified by the bank. The banker acceptance is mostly used in international trades and especially where the delivery of shipments is paid at a future date. Banker acceptance is similar to commercial paper. The only difference is its applicability in international trade.
A commercial paper is a financial security issued by large businesses to finance short-term credit obligations. Typically, the bank issues the commercial paper agreeing to pay the specified amount on the maturity date. The security is then sold at a discount to a willing buyer, who waits for the bank to pay the quoted amount on the maturity date. According to the international market standard regulators, the security takes 270 days to mature (Siddaiah 247). Commercial paper has a shorter maturity period than bonds. Hence, it has a lower interest rate than the bond. Although commercial paper is used for short-term financing purposes, a business can opt for a continuous rolling program that is perennial. The rolling program can last for many. Hence, it becomes an alternative to short-term loans since the rolling is done before 270 days elapse.
There are advantages and disadvantages of commercial paper as a short-term financing method for both the business and the economy. First, commercial paper has a lower interest rate than a loan from the bank. Consequently, it is more attractive to the borrowers. Second, it is readily available to businesses that have high creditworthiness and therefore, is suitable for financing short-term deficits that demand quick fixes (Piketty 75). Third, companies are willing to buy the commercial paper at a discount and wait to sell on the maturity date at a profit. Therefore, there are many buyers in the market to provide the required finances.
One disadvantage of commercial paper is that it denies a bank the opportunity to provide short-term loans to big businesses. Moreover, commercial paper is only issued to blue-chip companies that have a high credit rating and the ability to pay for its value. Also, commercial paper is in great demand, therefore resulting in the lowering of the credit limits of the commercial banks. It becomes hard for banks to provide loans to many customers. The issuance of commercial paper is highly controlled by the government. As a result, there is a limit that a borrowing business cannot exceed and a fixed deadline for the repayment (Piketty 78).
Lease financing is an agreement between the leaser and the lessee to have a legal right to use an asset on a rental basis. Leasing is mostly done by big businesses that have assets that are expensive and can be used by other firms on a rental basis. For instance, a company can lease heavy commercial vehicles to other businesses for a particular period, upon which the lessee will pay the rent (Piketty 79). Companies find hiring as an efficient method of seeking short-term financing since the obtained rental income can be used to cover deficits in the working capital.
Factoring is a method of short-term financing where a business opts to sell its account receivables to a third party at a discount. There are situations where a company has many unsettled receivables that can be sold at a discount to a factor to cover a deficit in the working capital. Some enterprises offer factoring services to businesses, and after buying the receivables at a discount they automatically assume the role of collecting the unsettled debts. Most short-term financing methods have the interest to be paid. Therefore, factoring is considered to be a good way of seeking finance whenever the value of pending invoices can cover the underlying deficit.
In conclusion, there are various short-term financing methods. However, every approach is different from others in different ways. Therefore, whenever a business is unable to meet the cost of working capital, it has to decide on the most appropriate method of financing to take. There should be working capital management policies that act as a guideline to the managers to mitigate risks that could arise from decisions made by people with unfavorable personal interests. Moreover, there are other factors to be considered to determine the most efficient method that can be used to finance a business. They include the business assets and the demand for goods and services. It helps to ascertain the ability of the company to repay the debt within a short period.
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Piketty, Thomas. Capital in the Twenty-First Century, Cambridge, Massachusetts: Harvard University Press, 2014. Print.
Pride, William, R. Hughes, and J. Kapoor. Business, Boston, Massachusetts: Cengage Learning, 2013. Print.
Sagner, James. Essentials of Working Capital Management, New Jersey: John Wiley & Sons, 2010. Print.
Siddaiah, Thummuluri. International Financial Management, New Delhi: Pearson Education India, 2010. Print.