Working capital policies are available to firms

Working capital policies are strategies adopted by firms in managing their working capital.

This concerns managing current assets such as accounts receivable, cash, inventory and current liabilities such as accounts payable.

In nowadays’ competitive business environment, firms ought to adopt efficient ways of carrying on with their operations. Such ways should include cost-cutting measures to boost profitability.

One of the ways to reduce the cost of doing business is to reduce the cost of capital.

To reduce the cost of capital, firms need to manage their internal sources of funding and their operations, and this could be done through crafting a working capital policy.

Thus, there should be a clear strategy on how trade payables, cash, trade receivables, inventories, and other short-term investments are to be managed so that the firm’s managers would not take bad decisions that will have negative effects on the firm.

This enables firms to reduce or eliminate the costs incurred on interests paid on funds [cost of capital] sought from outside the firm.

For a firm to have a workable working capital policy, the nature of its business operations has to be considered, as working capital requirements vary from firm to firm and from industry to industry.

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Firms need to take into account the credit policies of their competitors in arriving at their working capital policies or strategies. Otherwise, they may lose their customers to rival firms that have favourable credit terms.

Objectives of working capital policy
According to Zohrabi et al. (2013), the objectives of any working capital policy should be to minimise risk, have adequate and appropriate liquidity, and to maximise shareholders’ rights.

Other objectives are to improve financial flexibility, maximise profitability, and optimise working capital levels. The level of current assets and current liabilities a firm should hold is dependent on the type of working capital policy it adopts.

Working capital policies
Several criteria exist for classifying working capital policies. Notable ones are level of working capital investment, level of liquidity, level of risk, cash conversion cycle, as well as business and industry characteristics.

According to Panigrahi (2015), there are three policies that are geared towards a firm’s liquidity, risk, and profitability trade-off that it could adopt.

These are conservative, moderate and aggressive working capital policies.

Conservative Policy: This policy aims at reducing the risk associated with working capital by making substantial investments in current assets so that liquidity is guaranteed.

Though liquidity is prioritised, profitability is reduced as quite an amount of capital is locked up in liquid assets.

With conservative policy, non-current assets, current assets and some fluctuating current assets are financed by a combination of short-term and long-term funds.

It has the characteristics of a high liquidity level, low risk, stable funding sources and low levels of debt.

And, since the company is not so much reliant on short-term funds, risk is significantly reduced.

As a result of the risk-return trade-off [which posits that the higher the risk, the higher the return, likewise the reverse], profitability is thereby reduced since the risk level with this policy is lower.

Moderate Policy: This policy is positioned in-between conservative policy and aggressive policy in that it uses short-term funds to finance fluctuating current assets while utilising long-term funding sources to finance permanent current assets and non-current assets.

This eventually boosts profitability compared with a conservative policy.

Under this policy, both risk and return are carefully considered so that the risk appetite of the firm does not go so high and plunge the firm into a state of making losses.

Aggressive Policy: Aggressive policy is the riskiest of all the policies, yet it comes with commensurate returns.

It carries a high risk of keeping working capital at a low level against a high sales level.

By studying the impact of working capital management on liquidity, profitability and risk of bankruptcy, Panigrahi (2014) finds that a company that implements a working capital policy that is aggressive could earn a high profit margin even in a case where it has a negative working capital.

Research results (Mwangi et al., 2014) further indicate that aggressive policy has a significant positive impact on both return on assets (ROA) and return on equity (ROE).

Aggressive policy often results in capital minimisation in short-term assets against long-term investments, with the expectation of higher profits but with its accompanying higher risk.

This suggests that the firm is operating on lower levels of receivables, inventory and cash for a given level of activity or sales, and thus, there is a high probability that the firm may experience cash or inventory shortages at a point in time, which increases risk while increasing returns at the same time.

Thusly, Bei and Wijewardana (2012) posit that, as working capital is measured by the current assets to total assets ratio, a lower ratio indicates an aggressive working capital policy.

Conclusion
Firms must consider the desired rate of inventory turnover to keep them profitable, agreed credit periods from suppliers and the overall cash needs for smooth operations when deciding on their working capital policies or strategies.

Firms are thus advised to make careful considerations in arriving at a policy that best suits their situations.

The writers are members of The Chartered Institute of Tax Law and Forensic Accountants–Ghana, and Chartered Management Accountants, respectively.