Answer to Question #185315 in Management for Alex Baraka

Question

How does a company’s working capital policy impact on its liquidity – profitability position? Explain with reference to the strategies available to the firm for financing its working capital.

Answer 1

As the amount of working capital increases the liquidity of the business increases. For example, an increase in inventory increases liquidity but decreases profitability because the stock is kept idle. A higher amount of working capital enables a firm to meet its short-term obligations easier. So, it is possible to state that efficiency in working capital management affects not only short-term financial performance (profitability) but also long-term financial performance (firm value maximization).

There are three strategies of financing working capital;

1. Maturity Matching (Hedging)-  is an ideal method of financing with moderate risk and profitability.
2. Conservative approach- very low risk and therefore low profitability.
3. Aggressive approach- has high risk and high profitability.