If the amount of working capital is underestimated, then the company will constantly experience a lack of funds, have a low level of liquidity and, as a result, interruptions in the production process, loss of profit. Conversely, the more current assets exceed current liabilities, the higher the liquidity of the enterprise. But an increase in working capital compared to the optimal need for them leads to a slowdown in their turnover and also reduces profits. Thus, the working capital management strategy should be based on ensuring the solvency of the enterprise and determining the optimal volume and structure of working capital. In turn, determining the necessary need for working capital sets the financial manager the task of choosing the optimal structure of sources of financing working capital.
A comprehensive working capital management policy includes the management of current assets and current liabilities.
Management of current assets means determining their size, composition and structure.
The strategy for financing current assets is determined depending on what decision the financial manager makes regarding the sources of covering temporary needs, i.e. coverage of the variable part of working capital.
In financial management, four models of working capital management are distinguished: ideal, aggressive, conservative and moderate.
The ideal model for managing current assets and liabilities:
The very name "ideal" suggests that in practice it is extremely rare.
This is when current assets are fully covered by short-term liabilities. This model is risky in terms of liquidity. In the event of an extreme situation (the need for full settlement with the majority of creditors), the company will be forced to sell part of its fixed assets to cover current accounts payable.
Aggressive current assets and liabilities management model:
This is when the share of working capital is significantly higher than the share of fixed assets. The company has large stocks of raw materials, materials, finished products, significant accounts receivable. A short-term loan finances not only the variable part of current assets (temporary need for working capital), but also part of the permanent current assets. Obviously, the greater the share of short-term credit in the financing of permanent working capital, the more aggressive the financial policy. When managing working capital according to an aggressive model, the company's costs for paying interest on a loan increase, which reduces economic profitability and creates a risk of liquidity loss.
A conservative model for managing current assets and liabilities:
This is if the share of current assets is relatively low. Accordingly, the share of short-term financing in the total value of all liabilities of the enterprise is small. Only a part of the company's variable current assets is covered by a short-term loan. The rest of the need for working capital is covered by permanent liabilities. The financial manager chooses such a policy subject to a deep study of sales volumes, a clear organization of mutual settlements, and established relationships with suppliers of raw materials and materials. Conservative policy contributes to the growth of return on assets. At the same time, it contains elements of risk in case of unforeseen situations in the calculations or in the sale of products.
Moderate current assets and liabilities management model:
The moderate financial policy of working capital management is a compromise between an aggressive and conservative model. In this case, all parameters (economic profitability, turnover, liquidity) are averaged.
Based on a comprehensive assessment of the size, composition and structure of current assets, a financial manager can develop a comprehensive working capital management policy for each specific period of the enterprise's production activities.
♦ choosing the optimal level and rational structure of current assets, taking into account the specifics of each enterprise;
♦ determining the size and structure of their funding sources.
There are three types of asset management policies: aggressive, conservative and moderate.
Signs of an aggressive policy are as follows:
♦ the company does not impose any restrictions on the increase in current assets;
♦ it accumulates stocks of raw materials and materials, finished products, increases accounts receivable and free cash balances in bank accounts.
As a result, the share of current assets in the total volume of property is high (more than 50%), and their turnover period is long (over 90 days). An aggressive policy can reduce the risk of technical insolvency, but cannot ensure high profitability and turnover of current assets.
A characteristic feature of a conservative current asset management policy is that the company restrains the growth of current assets and seeks to minimize them. As a result, the share of current assets in the total volume of property is small (less than 40%), and the period of their turnover is relatively short (50-60 days). The company pursues such a policy in a fairly certain situation, when the volume of sales, the timing of the receipt of funds and payments on obligations, the required volume of stocks and the timing of their delivery are known in advance or with austerity of all types of resources. A conservative current asset management policy ensures a high return on assets. However, it carries the risk of high technical insolvency due to unforeseen changes in the business situation in the commodity and financial markets.
A moderate current asset management policy occupies an intermediate position. It is characterized by an average level of profitability and turnover of current assets (Table 6.4). Each type of management of current assets must correspond to a specific policy for their financing, that is, management of short-term obligations (liabilities). A sign of an aggressive policy of managing short-term liabilities is a significant (more than 50%) share of short-term credits and loans in the total amount of liabilities.
Table 4
Signs and results of calculating indicators for various types of current asset management policies for JSC
With such a policy, the company may increase the effect of financial leverage (leverage) up to 30-50% of the return on assets. However, fixed costs will also increase due to interest payments to lenders (banks). As a result, the strength of the impact of operating leverage (marginal income divided by operating profit) will also increase, which may indicate an increase in not only financial, but also entrepreneurial risk associated with this enterprise.
A sign of a conservative policy of managing short-term liabilities is the absence or low share (no more than 30-35%) of short-term loans and borrowings in the currency of the balance sheet liabilities. In this case, non-current and current assets are covered by equity and long-term liabilities.
A sign of a moderate policy is the neutral share of short-term loans and borrowings in the currency of the balance sheet liability (within 35-45%). It should be noted that with a conservative current asset management policy, it may correspond to a moderate or conservative type of short-term liability management. Any type of short-term liability management can be consistent with a moderate current asset management policy. Finally, an aggressive current asset management policy may correspond to an aggressive or moderate type of short-term liability management, but not a conservative one.
The conservative policy of managing current assets is characterized by a decrease in the share of current assets in the total assets of the enterprise and a high rate of their turnover. At the same time, the company reduces the size of inventories to a rational value, reduces the amount of receivables. The economic profitability of assets is growing, but at the same time the risk of technical insolvency is sharply increased. This policy is applied in the case when all delivery dates are precisely known, there is a high discipline of payments, or in the case when the company must save on absolutely everything.
A moderate current asset management policy is characterized by average values (parameters) of the share of current assets in the total assets of the enterprise and the average rate of their turnover. The economic profitability of assets, the risk of technical insolvency are at a certain average level.
Each type of such policy should be accompanied by a funding policy. Depending on the size of the share of short-term liabilities, the following policy options for managing short-term liabilities are distinguished as part of all liabilities.
The aggressive current liabilities management policy is characterized by the predominance of short-term loans in total liabilities. The strength of the effect of financial leverage increases. Fixed costs rise due to increased interest on loans, which inevitably leads to an increase in the strength of operating leverage. Used in conditions of uncertainty and high inflation. True, this increases the overall risk associated with the enterprise.
The conservative policy of managing current liabilities is characterized by a low share of short-term loans in the company's liabilities. Assets are financed mainly by long-term loans and borrowings, as well as own funds. In the short term, the impact of financial leverage decreases. However, the impact of the production lever is increasing (primarily due to interest payments on long-term loans). In this situation, there is a rather high predictability of the risk associated with the enterprise. Most often, such a policy is used in conditions of sufficient stability of the general economic situation.
A moderate current liabilities management policy is characterized by an average (compared to aggressive and conservative policies) level of the share of short-term credit in the total liabilities of the enterprise. The strength of the impact of financial and operational leverage is within the average values (the same applies to the level of risk associated with the enterprise).
The compatibility of various types of TA and TP management policies is illustrated by the policy selection matrix for the integrated operational management of TA and TP.
Table 1.1.1. Integrated Operational Management Matrix for Current Assets and Liabilities (Integrated Management Policy (CMP))