In brief, capital management refers to the short-term financial strategy of a company in relation to cash flow. As a Chief Operating Officer, Stefan Masuhr deals with capital management on a daily basis, working to deliver inventive strategies that propel margins. If you would like to know more about the definition of capital management, you can click on the PDF and video attachments to this post.
There are three main capital management strategies employed by businesses, referred to as conservative, aggressive and hedge strategies. Each has its own advantages and disadvantages and some are more suitable for certain types of company than others.
Conservative Capital Management Strategies
A conservative capital management strategy operates on a “low profit, low risk” basis, offering less reward but also more security. Conservative strategies offer greater liquidity, using more money from long-term funds than other strategies. This type of strategy places the company in a position to take full advantage of any new or sudden opportunities. However, it also runs the risk of large amounts of funds running idle, which means that profitability is reduced. The risk of potential bankruptcy is also very low due to the higher level of liquidity. Higher levels of working capital are required to run a conservative strategy and the utilization rates of assets are low.
Aggressive Capital Management Strategies
Aggressive capital management strategies focus more on profit than risk management, utilising short-term rather than long-term funds to manage cash flow. The interest cost is minimised as funds are never idle, which results in higher profits. However, the liquidity of the business is low, resulting in a higher risk of bankruptcy when unforeseen costs occur. A very low level of working capital is maintained in an aggressive capital management strategy. You can see the three main advantages of maintaining a low level of working capital in the infographic attachment to this post. The utilisation ratio of assets with an aggressive strategy is high.
Hedge Capital Management Strategies
Hedging is defined as a risk management strategy that involves taking positions in two different markets to offset risk. As such, a hedge capital management strategy falls somewhere in between a conservative or aggressive approach. Capital managers operating a hedge strategy strive to maintain a balance between profit and risk. There are many variations in hedge capital management strategy, and many varied procedures are used to manage return and risk in both the short-term and the long-term. In hedge capital management, liquidity is balanced and profits are moderate. As the overall risk is balanced, so long as the strategy is effective a hedge capital management strategy results in minimal risk of bankruptcy. Rates of asset utilisation and working capital are also maintained at moderate levels.
How Much Working Capital Do I Need?
The strategy you choose will in part depend on your capacity for risk versus your desire to increase profits. However, for small businesses in particular, positive working capital figures will almost always need to be maintained, as funds from elsewhere cannot always be raised easily. Businesses that require larger amounts of working capital include those that have physical inventory, particularly those that take a relatively long time to produce each product, or those that are seasonal in nature. Service providers or those that offer intangible products such as online software will have less need for large amounts of working capital. The current goals of the business also need to be considered – a business that is seeking to expand in the near future will require higher levels of working capital to facilitate that expansion.