Financing of Current Assets

Current assets of enterprises may be financed either by short-term sources or long-term sources or by combination of both. The main sources constituting long-term financing are shares, debentures, and debts form banks and financial institutions. The long term source of finance provides support for a small part of current assets requirements which is called the working capital margin. Working capital margin is used here to express the difference between current assets and current liabilities. Short-term financing of current assets includes sources of short-term credit, which a firm is mostly required to arrange in advance. Short-term bank loans, commercial papers etc. are a few of its components. Current liabilities like accruals and provisions, trade credit, short-term bank finance, short-term deposits and the like warranting the current assets are also referred to a short-term term sources of finance.Spontaneous financing can also finance current assets, which includes creditors, bills payable, and outstanding receipts. A product firm would always opt for utilizing spontaneous sources fully since it is free of cost. Every concerns that can no more be financed by spontaneous sources of financing has to decide between short-term and long-term source of finance along with relevant proportion of the two. There are three approaches of financing current assets that are popularly used. They are;

1. Matching Approach

As the name itself suggests, a financing instrument would offset the current asset under consideration, bearing financing instrument bearing approximately same maturity. In simple words, under this approach a match is established between the expected lives of current asset to be financed with the source of fund raised to finance the current assets. For this, reason a firm would select long-term financing to finance or permanent current assets to finance temporary or variable current assets. Thus, a ten-year loan may be raised for financing machinery bearing expected life of ten years. Similarly, one-month stock can be financed by means of one-month bank loan. This is also termed as hedging approach.

2. Conservative Approach

Conservative approach takes an edge over and above matching approach, as it is practically not possible to plan an exact match in all cases. A firm is said to be following conservative approach when it depends more on long-term financial sources for meeting its financial needs. Under this financing policy, the fixed assets, permanent current assets and even a part of temporary current assets is provided with long-term sources of finance and this make it less risky nature. Another advantage of following this approach is that in the absence of temporary current assets, a firm can invest surplus funds into marketable securities and store liquidity.

3. Aggressive Approach

As against conservative approach, a firm is said to be following aggressive financing policy when depends relatively more on short-term sources than warranted by the matching plan. Under this approach the firm finance not only its temporary current assets but also a part of permanent current assets with short-term sources of finance.In nutshell, it may be concluded that for financing of current assets, a firm should decide upon two important constraints; firstly, the type of financing policy to be selected (whether short-term or long term and secondly, the relative proportion of modes of financing. This decision is totally based on trade-off between risk and return. As short-term financing is less costly but risky, long-term financing is less risky but costly.

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