Approaches to Working Capital Financing

Having dealt with the size of investment in current assets, the methods of financing of working capital needs our attention. Working capital is financed both internally and externally through long-term and short-term funds, through debt and ownership funds. In financing working capital, the maturity pattern of sources of finance depended much coincide with credit period of sales for better liquidity.

Generally, it is believed that funds for acquiring the fixed assets should be raised from long term sources and short-term sources should be utilized for raising working capital. But in the recent modern enterprises, both the types of sources are utilized for financing both fixed and current assets.

There are basically three approaches to financing working capital. These are: the Hedging approach, the Conservative approach and the Aggressive approach.

  1. Hedging Approach: The hedging approach is also known as the matching approach. Under this approach, the funds for acquiring fixed assets and permanent current should be acquired with long term funds and for temporary working capital short term funds should be used.
  2. Conservative Approach: This approach suggests that in addition to fixed assets and permanent current assets, even a part of variable current assets should be financed from long-term sources. The short-term sources are used only to meet the peak seasonal requirements. During the off season, the surplus fund is kept invested in marketable securities. Surplus current asset enable the firm to absorb sudden variation in sales, production plans, and procurement time without destructing production plans. Additionally the higher liquidity level reduces the risk of insolvency. But lower risk translates into lower returns. Large investment in current asset lead to higher interest and carrying cost and encouragement for efficiency. But conservative policy will enable the firm to absorb day to day risk. It assures continuous flow of operation and illuminates worry about recurring obligation. Under this strategy, long term financing covers more than the total requirement of capital. The excess cash is invested in short-term marketable securities and in need these securities are sold off in the market to meet the urgent requirement of working capital.
  3. Aggressive Approach: This approach depends more on short-term funds. More short-term funds are used particularly for variable current assets and a part of even permanent current assets, the funds are raised from short term sources. Under this approach current assets are maintained just to meet the current liabilities without keeping cushions for the variation in working capital needs. The companies working capital is financed by long-term source of capital and seasonal variation are met through short-term borrowing. Adoption of this strategy will minimize the investment in net working capital and ultimately it lowers the cost financing working capital needs. The main drawback of this strategy is that it necessitates frequent financing and also increase, as the firm is variable to sudden shocks.

Risk preferences of management shall decide the approach to be adopted. The risk neutral will adopt the hedging approach, the risk averse will adopt the conservative approach and risk seekers will adopt the aggressive approach.

Following table gives a summary of the relative costs and benefits of the three different approaches:

Factors

Conservative

Aggressive

Hedging

Liquidity

More

Less

Moderate

Profitability

Less

More

Moderate

Cost

More

Less

Moderate

Risk

Less

More

Moderate

Asset utilization

Less

More

Moderate

Working capital

More

Less

Moderate

Thus management of working capital is concerned with determining the investment needed and deciding the financing pattern. You would be now knowing that deciding the financing pattern is essentially determining the size and composition of current liabilities in relation to those of current assets. Cost of different types of funds (the long-term and short-term funds), the return on different type of current assets, ability to bear risk, desired liquidity levels, etc. have to be considered to decide working capital management related issues.

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