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How Do I Choose the Best Working Capital Policy?

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  • Written By: N. Madison
  • Edited By: Jenn Walker
  • Last Modified Date: 01 October 2014
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It can be difficult to choose the best working capital policy, and the policy that works best for another businessperson may not be best for you. In general, however, the best policy may be the one that features a level of risk you can handle. A conservative working capital policy may prove best for you if you want to keep risk low. A matching policy, on the other hand, entails a medium level of risk but also leaves you with more cash to reinvest in your business. An aggressive working capital policy is considered the highest risk but may translate into more funds to reinvest in your business.

A matching type of policy may prove to be the best option if you want to have a significant amount of money available to reinvest in your business but don’t want to take on an extremely high level of risk. With this policy, you make sure that your business assets are matched with your business liabilities. You plan so that you will have money to pay your creditors when your payments are due, but you may reinvest the funds on hand in the meantime in the hopes of increasing profits for your business.

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If you prefer a less risky policy, you may choose a conservative plan. In such a case, you will typically match your business assets and liabilities in order to make sure you will have the money to pay creditors. To reduce risk, however, you may also retain additional assets for the purpose of having money available for unforeseen circumstances. While you may prefer this working capital policy because it involves little risk, choosing it may mean you have less money for business growth.

An aggressive policy for working capital may allow you to grow your business quickly but involves taking on a high level of risk. In such a case, you collect funds you are owed quickly and delay paying creditors for as long as possible. With this plan, you can use the money you receive from debtors and the money you owe creditors to increase productivity and afford quick business growth. This may allow you to see an increase in sales and profits faster than usual. It may, however, also force you to sell assets or look for other sources of funding in the event a creditor demands payment sooner than you expected.

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everetra
Post 4

@hamje32 - Given the current economic climate, I think most businesses should opt for a conservative policy.

There is no need to expose yourself to more risk than you have to. Also, keep in mind that even if you wanted to take on greater risks, you might have a more difficult time getting the necessary loans.

Banks have become much more selective about who they lend money to. It’s better to make sure you have the best business plan possible in my opinion, and downplay your projections when approaching the funding source.

hamje32
Post 3

@nony - I worked in telecommunications for years, and I can tell you that industry is very infrastructure intensive. Frankly I don’t know why anyone would bother getting involved.

You have to buy massive amounts of equipment and stuff just to get up and running, at least if you want to offer a nationwide phone service at competitive rates. Liabilities definitely exceeded assets, and all we were concerned about was “servicing the debt,” which meant making the minimum payment on it while the network was being built out.

It was an aggressive approach, but it went bust. We simply couldn’t generate enough profits and we had billions of dollars in liabilities. The only option was to file for bankruptcy.

nony
Post 2

@Mammmood - We’re in a unique situation. Actually I’m not sure which scenario our company fits in here.

We are small software company and the business was funded primarily through the sales of the software products. As a matter of fact, it took out almost no loans to start. It just kept selling more products and kept the business going that way.

I think we have one loan on a building we purchased but that isn’t a lot. I want to say that our policy is conservative, since our assets exceed our liabilities. On the other hand, the business is growing at a steady clip. It certainly doesn’t feel conservative.

Perhaps if we took out loans however we could take on some more ambitious projects and really start to explode. Being hemmed in by monthly cash flow does have a restraining effect, especially during the summer months.

Mammmood
Post 1

I think a lot of the Internet startups in the late 1990s used an aggressive working capital policy. They got a lot of money from angel investors and poured that money into the business, while delaying any concerns about paying off liabilities.

Many of these companies of course were funded by IPOs and their stocks went through the stratosphere. They rode that rapid acceleration of stock price in order to continue to fund the business.

It was far from a conservative approach and it assumed that stock prices would keep going higher and higher. I rode part of that boom and gut burned when it went bust.

While I’m not in business myself, I think I would prefer the matching policy. Make sure you have enough money to pay your liabilities, even if it means you have less cash on hand and have to move like a tortoise racing a hare.

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