In the conservative approach, fixed assets, permanent working capital and a part of temporary working capital is financed by long-term financing sources and the remaining part only is financed by short-term financing sources. Thus, the primary objective of working capital management is ensured. It is explained in the equation below:
Financing Strategy in Equation
Long Term Funds will Finance = Fixed Assets + Permanent Working Capital + Part of Temporary Working Capital
Short Term Funds will Finance = Remaining Part of Temporary Working Capital
Conservative Approach Diagram
To explain the approach with more clarity, let us use the following diagram. The dotted lines horizontal line indicates the point till which the long-term funds will be utilized. The dotted vertical lines indicate the sources of finance and they are tagged as ‘long-term financing’ and ‘short term financing’.
We can easily make out that long term funds are financing total fixed assets, total permanent assets and a part of the temporary or seasonal working capital also. Seasonal requirement or temporary working capital has peaks and troughs. The two areas of troughs below the long-term financing line indicate that there are idle long term funds incurring unnecessary interest cost.
Advantages of Conservative Strategy of Working Capital Financing
Smooth Operations with No Stoppages
In this strategy, the level of working capital and current assets (inventory, accounts receivables and most importantly liquid cash or bank balance) is high. A Higher level of inventory absorbs the sudden spurt in product sales, production plans, any abnormal delay in procurement time etc. This achieves the higher level of customer satisfaction and smooth operations of the company.
Higher levels of accounts receivables are due to relaxed credit terms which in turn attracts more customer and thereby higher sales and higher sales mean higher profits in normal circumstances.
No Insolvency Risk
Most important part and highly relevant to financing strategy are the higher levels of cash and working capital. Higher working capital avoids the risk of refinancing which exists in case it is financed by short-term sources of finance. Not only the risk of refinancing but also the risk of adverse change in the interest rate while getting the short term loans renewed are avoided. This is how the insolvency risk is avoided as at any time company has sufficient capital to pay off any liability.
Disadvantages of Conservative Strategy of Working Capital Financing
Higher Interest Cost
This strategy employs long-term sources of finance and hence there are all the chances that the rate of interest will be high. The theory of term premium says that the long-term funds have higher interest rate compared to short-term funds as risk perception and uncertainty is high in case of longer terms.
Long term loans cannot be paid off when wished and if paid cannot be easily availed back. As we noted in the diagram, the long-term funds remain unutilised in the times when seasonal spurt in activity is not there. Idle funds have an opportunity cost of interest attached to it.
Higher Carrying Cost
A Higher level of inventory and debtors implies higher carrying and holding cost which has a direct impact on profitability.
Inefficient Working Capital Management
If the margins of the firm are low for a particular year, a reasonable part of it will be attributed to working capital management. In such a situation, the conservative approach of financing may be called with another name of ‘inefficient working capital management’.Last updated on : February 22nd, 2018