Managing working capital efficiently is a challenge for all small-business owners. If working capital is too low, bills aren't paid on time, and companies miss sales opportunities because of a lack of funds. On the other hand, keeping excess working capital is an inefficient use of capital.
Finding a balance that maximizes profits and minimizes risks at the same time is challenging but possible. An aggressive financing strategy to manage working capital may be part of the solution.
What Is an Aggressive Financing Strategy?
Working capital has two components: permanent and temporary. These components can be financed with a combination of long-term and short-term funds.
With a moderate approach, companies use long-term funds to finance all noncurrent assets and the entire permanent portion of working capital. They use short-term borrowings to fund seasonal or temporary fluctuations in working capital above the permanent component.
An aggressive financing strategy, on the other hand, uses short-term funds to finance temporary fluctuations in working capital plus a portion of the permanent component of working capital. Long-term debt funds all noncurrent assets plus the remaining portion of permanent working capital not funded with short-term loans.
Advantages of an Aggressive Working Capital Policy
An aggressive working capital policy increases profits by taking advantage of the interest rate differential that usually exists between long-term and short-term debt. Short-term rates are typically lower than long-term rates.
In addition, short-term loans can be repaid when they are no longer needed, unlike long-term debt, which remains outstanding until maturity. This eliminates having unprofitable idle funds on hand.
Disadvantages of an Aggressive Working Capital Financing Policy
An aggressive financing policy is risky because short-term rates are more volatile and subject to large interest rate swings. Interest rates on new loans needed to replace maturing loans could have higher interest rates than previous borrowings, which would increase costs and lower profits.
A possible lack of liquidity is the most significant risk. No cash is maintained in reserve to cover any unexpected needs in working capital, which must be financed by immediate borrowings.
Businesses are vulnerable to any interruptions to the availability of short-term borrowings. Lenders may be reluctant to extend loans during uncertain economic periods.
As an example, if short-term borrowings are not available, a firm may be forced to resort to invoice factoring or discounting of invoices, both of which have considerably higher interest costs and fees. While expensive, invoice factoring may be better than waiting 90 or 120 days for customers to pay when you are faced with cash flow constraints and need money quickly.
What Is a Conservative Working Capital Financing Policy?
With a conservative strategy, long-term funds are used to finance all noncurrent assets, the entire amount of permanent working capital requirements plus a portion of temporary working capital needs. This strategy occasionally results in idle excess funds.
Companies can invest any excess cash available from this conservative strategy in short-term marketable securities, which they can sell quickly to cover any immediate needs for working capital.
A conservative working capital financing policy has the least reinvestment and interest rate risk. It maintains the highest liquidity level and has funds ready when needed without the need to resort to additional outside borrowings.
Disadvantages of Conservative Strategy of Working Capital Financing
Financing of temporary working capital with long-term funds results in increased interest costs when funds are idle. Firms incur interest expense when they have excess funds on hand and no need for additional temporary working capital.
The lower risk of a conservative strategy also results in reduced profits because of the higher interest rate costs of long-term debt.
Managers who are risk-takers are more comfortable with an aggressive financing strategy. It is the most profitable method of managing working capital, but it comes with the most risk. The conservative approach is less profitable but has the least risk.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.