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: 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. This approach depends upon the long-term sources to a great extent.
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.

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:

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.