The aggressive approach is a high-risk strategy of working capital financing wherein short-term finances are utilized not only to finance the temporary working capital but also a reasonable part of the permanent working capital. In this approach of financing, the levels of inventory, accounts receivables and bank balances are just sufficient with no cushion for uncertainty. There is a reasonable dependence on the trade credit.
Fixed assets and a part of permanent working capital are financed by long-term financing sources and the remaining part of permanent working capital and total temporary working capital is only is financed by short-term financing sources. It is explained in the equation below:
- Financing Strategy in Equation
- Advantages of Aggressive Strategy of Working Capital Financing
- Disadvantages of Conservative Strategy of Working Capital Financing
Financing Strategy in Equation
Long Term Funds will Finance = Fixed Assets + Part of Permanent Working Capital
Short Term Funds will Finance = Remaining Part of Permanent Working Capital + Temporary Working Capital
Aggressive Approach Diagram
For better and clear understanding, following diagram is utilized. The dotted lines horizontal line indicates the point till which the long-term funds will be utilized. The dotted vertical lines indicate the sources of finance and they are tagged as ‘long-term financing’ and ‘short term financing’.
We can easily make out that long term funds are financing total fixed assets and a part of permanent assets. A major part of Seasonal requirement or temporary working capital is financed by short term source of finance. In this approach, the difficult area is the part of permanent working capital which is financed by short-term sources. It can pose problems of liquidity and bankruptcy to the firm.
Advantages of Aggressive Strategy of Working Capital Financing
Lower Financing Cost, High Profitability
In this strategy, the cost of interest is low because of the maximum usage of short term finances. There are two reasons of this. Firstly, the rate of interest is cheaper and secondly, in the off seasons, the loan can be repaid and hence, no idle funds. If the operating cycle is moving smoothly, it is called most effective working capital management.
Lower Carrying and Handling Cost
Lower level of inventory makes the carrying and holding cost also go down and that directly affect the profitability.
Highly Efficient Working Capital Management
The task of working capital manager is to smoothly run the operating cycle of the company with the lowest level of working capital. Precisely, that is what this strategy is all about. If the strategy is successful with no dissatisfied stakeholders, there is nothing better than this.
Disadvantages of Conservative Strategy of Working Capital Financing
This strategy faces the high level of insolvency risk because the permanent assets are financed by the short-term financing sources. To maintain those permanent assets, the firm would need to be repeated refinancing and renewals. It is not necessary that all the time the refinancing is smooth. For any reason, if the financial institution rejects the renewal, the firm will not be in a position to maintain those permanent assets and will have to forcibly sell them. If failed in realizing those assets, the options left is liquidation. Liquidating the permanent working capital is very difficult as it consists of accounts receivables and inventory.
Lost Opportunities and Unexpected Shocks
Since, there is no cushions or margin in this strategy of financing, sudden big contracts of sales are not possible to execute. On the other hand, if there are other uncertainties like delay in an abnormal raw material acquisition, machinery break downs etc, the firm will disturb the business operating cycle and therefore will face sustainability problems.