How does management determine how working capital should be financed? A company's Net Operating Working capital rises and falls seasonally and with business cycles.

1. How much NOWC to carry and how to finance it is a company's continuous balancing act?

2. What are the types of NOWC financing policies, and how do they affect a company?

1:

Working capital is one of the most difficult financial concepts for the small-business owner to understand. In fact, the term means a lot of different things to a lot of different people. By definition, working capital is the amount by which current assets exceed current liabilities. However, if you simply run this calculation each period to try to analyze working capital, you won't accomplish much in figuring out what your working capital needs are and how to meet them.

A more useful tool for determining your working capital needs is the operating cycle. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of days. In other words, accounts receivable are analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in your door to the point it is converted to cash or an account receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice.

Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two.

Most businesses need short-term working capital at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable buildup.

Some small businesses have enough cash reserves to fund seasonal working capital needs. However, this is very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard, you might miss out on the one big order that could put your business over the hump.

Here are the five most common sources of short-term working capital financing:

1. Equity. If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. These funds might be injected from your own personal resources or from a family member, a friend or a third-party investor.
2. Trade creditors. If you have a particularly good relationship established with your trade creditors, you might be able to solicit their help in providing short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that should not be a problem.
3. Factoring. Factoring is another resource for short-term working capital financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection. This type of financing is more expensive than conventional bank financing but is often used by new businesses.
4. Line of credit. Lines of credit are not often given by banks to new businesses. However, if your new business is well-capitalized by equity and you have good collateral, your business might qualify for one. A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
5. Short-term loan. While your new business may not qualify for a line of credit from a bank, you might have success in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup

2:

Net operating working capital (NOWC) is the excess of operating current assets over operating current liabilities. In most cases it equals cash plus accounts receivable plus inventories minus accounts payable minus accrued expenses

Working capital is a significant factor in a company’s operational competency. Proper management of working capital ensures sufficient availability of funds to finance the day-to-day operations of an organisation, as well as, to fulfill growth and expansion targets. Thus, experts often consider it to be a precursor to a business’s success or failure.

To that end, several businesses opt for working capital financing options. However, the policy a business undertakes to finance its working capital is of utmost significance. With an inept policy, an organisation’s funds may remain underutilised, its growth may be hindered, or worse, it could face immense losses.

Thus, it requires a clear understanding of different working capital financing strategies to produce the most optimal results.

What Are The Different Working Capital Financing Policies?

In general, working capital policies involve determining the sources of finance. It also determines the allocation of these finances towards current assets and liabilities. Broadly, three strategies can help optimise working capital financing for a business, namely, hedging, aggressive, and conservative, as per the risk levels involved.

1. Conservative Policy

An organisation undertakes this strategy only when it requires minimising risk to the furthest. Under this policy, the management regulates the credit limits stringently to ensure low risk.

Moreover, current assets are always above par against the current liabilities to ascertain sufficient availability of funds.

Organisations majorly utilise long-term funding options to finance fixed and fluctuating current assets. The use of short-term sources is kept to a minimum for low-risk.

Observing a conservative working capital financing policy, hence, leads to underutilisation of funds, thus cutting down on returns and compromising growth.

2. Aggressive Policy

As the name may suggest, aggressive policies involve the maximum risk, and thus, also bring the potential for multiplied growth.

When observing this strategy, companies ensure their current assets, such as the value of debtors, are minimised by ensuring timely payments or minimum credit sales. At the same time, management also maintains that payments to creditors are delayed to the furthest.

Organisations aiming at accelerated growth can opt for this working capital policy. However, since it involves immense risk, strong business acumen, and deft handling of finances are critical.

3. Hedging Policy

Also known as matching policy, adopting this strategy ensures that the current assets of a company are always in sync with short-term liabilities.

In essence, this working capital financing policy aims to balance the two extreme strategies, both in terms of risk and growth potential.

Most organisations observing this strategy use long-term sources of finance to invest in fixed current assets and resort to short-term funding options for current asset financing.

Comparison Of Working Capital Financing Policies

When considering an ideal financing strategy for your organisation, taking into account the following parameters may benefit:

• Liquidity

While following an aggressive strategy, liquidity is usually low since short-term funds are primarily used to finance both fixed and fluctuating current assets. A company is thus left with minimal idle funds.

Conversely, in the case of a conservative strategy, liquidity is usually high. It is because companies mainly use long-term sources of finance, which leaves them with sufficient idle funds to address emergencies.

Hedging strategy involves moderate liquidity, ensuring a balance between idle funds and their cost.

• Profitability

In a conservative approach, interest cost is higher compared to the other two working capital policies. Thus, naturally, it lowers profits. In general, aggressive policies offer the highest returns since the cost involved is kept to a minimum. As you can guess, in observing the matching strategy, profits generated are moderate.

• Working Capital Requirement

Under a conservative approach, the working capital you need to maintain is substantial as it involves the provision of idle capital for exigencies. Under an aggressive strategy, the working capital requirement is notably low, which speaks to high risk, but the cost is saved. When considering the hedging policy, this factor is neither too high, nor too low.

The Bottomline

Consider these and other factors relevant to your business judiciously before adopting any particular policy. The growth stage of your company at any point in time can be a significant consideration when adopting the working capital financing policy