Conservative working capital investment policy

A conservative investment policy should not lead to liquidity problems and does not mean that the level of working capital is high. The object is to make sure that current assets are sufficient to cover the current liabilities, and to reduce the possibility of liquidity problems.

Overcapitalisation does not directly relate to the investment policy. It occurs when the overall level of working capital is higher than needed for the type and size of the business, regardless of the policy regarding how it is invested.

Overtrading also is not related to the investment policy. It is when a company is expanding rapidly but has not prepared for the fact that higher sales will result in higher receivables, inventory etc., as I explain in my free lectures.

1. More investment in working capital is needed if there are higher receivables and higher inventory. They are not increased just to create more liquidity – they may be higher because the business is growing and therefore will automatically have more receivables and more inventory, or they may be higher because the company is not managing them well.

2. The overall ‘reasonable’ level of working capital depends on the type of business (for example, a manufacturing company will need more inventory than a service business) and on the size of the business (a business with much higher sales will need more working capital than one with a lower level of sales). If company has a conservative policy then the level of working capital in proportion to the size of the business will be higher than the industry average for their type of business.