The objective of working capital management is to strike a balance between profitability and liquidity. Many high-tech firms that rely almost solely on IT infrastructures often find it difficult to make economically sound decisions when it comes to working capital funding for IT investment
- Non-current assets. These are long-term assets from which an organization expects to derive economic benefit from over a number of periods. For example, servers and other forms of database equipment.
- Permanent current assets. These are the amounts required to meet long term minimum needs and sustain normal trading or servicing function of the company. For example, the average bandwidth or storage device to be maintained at all time.
- Fluctuating current assets. These class of assets are those current assets which varies according to normal business activities. For example, due to seasonal variation, the computing power required to meet the demands of customers in a particular period of the year might either increase or decrease.
Fluctuating and Current assets together with permanent current assets form part of the working capital of an IT company, which may be financed by either long-term funding (including equity capital) or by current liabilities (short-term funding).
Approaches to working capital funding
There are basically three approaches to working capital funding VIZ;
- Aggressive Approach. This method encourages managers to finance all fluctuating assets and part of permanent assets with short-term funds. This is a more risky but more profitable approach to working capital management.
- Moderate Approach. As the name implies, fund are used according to the nature of the asset(s) being financed. A common practice is to finance all non-current assets with long-term funds, all fluctuating assets with short-term funds and to split permanent asset in such a way that long and short term funds will finance the assets equally.
- Conservative Approach. This is a method that finances all non-current assets and permanent assets as well as part of the fluctuating current assets by long-term funds. This is a less risky approach. The down side of it is that it is equally less profitable.
Depending on the attitude of the company towards risk, the nature of the asset is supposed to go a long way in determining the method of funding that is required. Many of the failures experienced among the dot com companies in the past decade or so is largely due to the fact that these companies violates the matching principle, which suggest that long-term finance should be used for long-term assets or projects and vice versa without taking some risk benefit factors into consideration. Working capital management is arguably the best way to achieve a balance between risk and returns.
Factors to consider
For simplicity, the factors to be considered while making working capital funding decision will be listed in bulleted format below
- The nature of the assets in question
- The management’s attitude towards risk, return and safety
- The company’s industry norm (those in sectors that require longer time to deliver result will obviously require more funding
- Availability of cash
- The previous working capital funding tradition of the company (experience plays significant role here)
- Technological trend
- Demand trend of the company’s service
My experience in the field of It and finance has made me conclude that tending towards what I call ‘the adjusted moderate approach’ will be the best policy to adopt. The reason for my opinion is the fact that the IT industry as a whole needs an average of eighteen (18) months only for changes that is capable of rendering so many assets obsolete to come.
Adjusted moderate approach is a tweak between moderate approach and aggressive approach. This is a method of financing fluctuating current assets purely by short-term loan (bank over-draft preferably) and outsourcing the provision of permanent current assets.
This is because the so-called permanent assets are not really permanent and it will not be wise to put in money in them as they are bound to change soon.
Applying adjusted moderate approach to working capital will help every IT company maximize returns from investments in IT infrastructures.