Financing Approaches to working capital

Recently updated on April 13th, 2023 at 06:31 pm

The Hedging or Matching Approach:

The term ‘hedging’ usually refers to two off-selling transactions of a simultaneous but opposite nature which counterbalance the effect of each other. With reference to financing mix, the term hedging refers to ‘a process of matching maturities of debt with the maturities of financial needs’.

According to this approach, the maturity of sources of funds should match the nature of assets to be financed. This approach is, therefore, also known as ‘matching approach’.

This approach classifies the requirements of total working capital into two categories:

(i) Permanent or fixed working capital which is the minimum amount required to carry out the normal business operations. It does not vary over time.

(ii) Temporary or seasonal working capital which is required to meet special exigencies. It fluctuates over time.

The hedging approach suggests that the permanent working capital requirements should be financed with funds from long-term sources while the temporary or seasonal working capital requirements should be financed with short-term funds. The following example explains this approach.

The Conservative Approach:

This approach suggests that the entire estimated investments in current assets should be financed from long-term sources and the short-term sources should be used only for emergency requirements. The short-term funds will be used only to meet emergencies.

For working capital financing, this financing strategy requires an organization to maintain high levels of current assets in relation to its sales. Such surplus current assets can incorporate any changes in the sales and thus avoid disruption in the production plans.

The distinct features of this approach are:

(i) Liquidity is severally greater

(ii) Risk is minimized

(iii) The cost of financing is relatively more as interest has to be paid even on seasonal requirements for the entire period.

Trade-off Between the Hedging and Conservative Approaches:

The hedging approach implies low cost, high profit and high risk while the conservative approach leads to high cost, low profits and low risk. Both the approaches are the two extremes and neither of them serves the purpose of efficient working capital management.

A trade-off between the two will then be an acceptable approach. The level of trade off may differ from case to case depending upon the perception of risk by the persons involved in financial decision-making.

However, one way of determining the trade-off is by finding the average of maximum and the minimum requirements of current assets or working capital. The average requirements so calculated may be financed out of long-term funds and the excess over the average from the short-term funds.

The Aggressive Approach:

The aggressive approach suggests that the entire estimated requirements of currents asset should be financed from short-term sources and even a part of fixed assets investments be financed from short-term sources. This approach makes the finance-mix more risky, less costly and more profitable.

For working capital financing, under this approach, the reliance is on short-term funds that are used for maintaining the current assets. These current assets are maintained only to meet the current liabilities and do not provide any cushion for the variation in working capital requirements.

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

Leave a Reply

error: Content is protected !!