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(^182) Financial Management
The three types of policies are shown in figure 6:
Figure 6: Types of Financing Policies
As you can see in the figure 18.1, a company that keeps a flexible policy keeps enough
liquid assets that are sufficient to finance its peak requirements of working capital. This
means that the company invests the excess money that it has when there is less than
the peak demand. A company with a restrictive policy keeps enough liquid assets that
are sufficient to meet the lowest level of working capital requirements. This means that
the company borrows as the seasonal needs grow to fund its working capital needs.
With a compromise policy, the firm keeps a reserve of liquidity which it uses to initially
finance seasonal variations in current asset needs. Short-term borrowing is used when
the reserve is exhausted.
A restrictive policy is associated with higher risk and higher expected profitability. A
conservative policy ensures higher liquidity and cover risk but is always accompanied
by lower profitability. The policy to be adopted is based on managementsí perception of
the risk with a view to maximise the utility value of the funds used in the working capital
management. This means that the risk-return trade-off is to be kept in mind while
formulating the WC policy.
Flexible policy means that the company is carrying excess cash and hence bearing
higher carrying costs than the other two policies. Restrictive policy means that the
company is out of cash many times and hence carries shortage costs like loss of orders,
etc. This is depicted in the figure 3.2 below:
Figure 7: Carrying Costs and Shortage Costs
Rupees
Amount of
current assets (CA)
Total cost of
holding current
assets
Carrying
costs
Shortage
costs
Minimum
point
CA*
The optimal amount of current assets.
This point minimizes total costs.