There are several tools for developing a robust working capital management process that can help to keep your business strong and display growth potential to partners and investors.
Mastering these could give you a competitive edge.
I. Working capital financing policy (WCFP)
A working capital financing policy (WCFP) is used to identify sources of income and determine the best way to allocate resources towards your current liabilities and assets.
There are three widely recognised types of WCFP: Conservative, Aggressive, and Hedging.
- Conservative WCFP: This financing policy type is designed to minimise risk. It is used when assets are in short supply, uncertain, or diminishing. A conservative policy tends to lead to the under-utilisation of funds, thereby reducing returns and compromising growth.
- Aggressive WCFP: An aggressive policy directs an organisation to utilise funds more liberally. Such a policy is advisable when the assets column stacks up robustly against the liabilities column and when cash flow into your pockets is steady and sure, or as sure as it can be. Aggressive WCFP elevates risk and is advisable only when you can afford to take on greater risk.
- Hedging WCFP: Sometimes referred to as a matching policy, a hedging WCFP is designed to balance the extremes of conservative and aggressive policies. Such a policy is adopted when the market, demand, supply, regulatory requirements, and other factors make this middle-of-the-road type of policy make sense. It can be a difficult balance to find.
II. Economic order of quantity (EOQ)
An economic order of quantity (EOQ) is calculated by minimising the cost per order by setting your first-order derivative to Zero. This measurement is used to determine the frequency and volume of orders needed to satisfy the current level of demand while keeping the cost of fulfilling orders at a minimum. EOQ can help your company to lower the cost of buying and holding inventory.
The Just in Time (JIT) style of capital management is a way of managing capital that correlates revenue or assets to expenses, or liabilities. You will notice that it is similar in essence to WCFP hedging. In other words, it attempts to steer the company's asset expenditure based on market conditions, assets, and liabilities. It is used to anticipate the incoming flow of cash and to allocate spending in such a way so that a minimal amount of cash is ever idle at any given time.
IV. Cash budgeting
Capital management, in part, means paying debts when they are due and keeping the level of idle cash at a minimum. This is part of the reason why we choose a working capital financing policy to suit current conditions, in order to keep an adaptive amount of cash working for us while avoiding unbearable levels of risk. A cash budget can be used to project cash flows, determine the optimal level of cash usage through an appropriate risk/reward balance, and put an amount of cash to work for you that you can afford.
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