OPTIMAL WORKING CAPITAL POLICY

The trade-off between the effects of increasing working capital and the effects of reducing liquidity risk, it can be argued that working capital should be increased if and only if the benefits exceeds the costs.  At least initially, increase in working capital may lead to increase in firm’s value, because the marginal benefits are likely to exceed the costs.  At some level of working capital, holding all other factors constant, the firm’s value should be maximized.  This is the optimum level of working capital for the firm.  In general, the working capital as a measure of liquidity risk suggests that increasing working capital will generally; reduce the liquidity risk faced by the firm, whereas decreasing the working capital will generally increase the liquidity risk.  The effects of working capital changes on the liquidity risk depend on a number of factors such as:

a)    Stand-by sources:  A firm with stand-by sources of external financing is less exposed to liquidity risk than the firm which does not have such access, because the former can tap these sources if it needs to cover the increasing current liabilities.

b)    Economic Conditions: Holding other factors constant, firms typically experience larger changes in liquidity risk as a consequence of working capital change when the economy is in recession than when it is in boom.

c)    Future Uncertainty:  To the extent that future operations of the firm are predictable and stable, the firm can survive with lower investment in working capital than could, otherwise similar firms which have more uncertainty about the future operations.

Therefore, the working capital policy adopted by a firm should be framed after due consideration of a host of factors.  It would be better if the working capital policy is viewed and framed in terms of separate assets and liabilities policies.  A conservative firm will tend to have conservative policies for both the current assets and the current liabilities, while an aggressive firm will tend to have aggressive policy for both the current assets and the current liabilities.  In fact, a firm should strive for an overall optimal working capital policy for which the following points are worth noting:

i)    Individual current assets and current liabilities policies should be framed so as to reduce or avoid larger degree of risk in any such policy.

ii)    One aggressive policy may be off-set by another conservative policy.  The overall result will tend to be moderate working capital policy for the firm.  Such a moderate policy will be optimal working capital policy for the firm.  This will help in maximizing the value of the firm for the level of risk assumed by the firm.

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