Financing Working Capital
Financing Working Capital
The financing of working capital is of utmost important. What portion of current assets should be financed by current liabilities? What portion should be financed by long-term resources? Decisions on these questions will determine the financing mix.
Approaches to financing mix:
There are 3 basic approaches to determine an appropriate financing mix. They are a. Hedging or Matching approach. b. Conservative approach. c. Trade-off between the above two. a. Hedging approach:
The term hedging can be said to refer to a process of matching maturities of debt with the maturities of financial needs. According to this approach, the maturity of the sources of funds should match the nature of the assets to be financed. For the purpose of analysis, the assets can be broadly classified into two classes:
1. Those assets which are required in a certain amount for a given level of operation and hence do not vary over time 2. Those assets which fluctuate over time
The hedging approach suggests that the long-term funds should be used to finance the fixed portion of current assets requirements. Purely temporary requirements, i.e., the seasonal variations over and above the permanent financing needs should be appropriately financed with short-term funds. b. Conservative approach:
This approach suggests that the estimated requirements of total funds should be met from long-term sources; the use of short-term funds should be restricted to only emergency situations or when there is an unexpected outflow of funds. c. Aggressive approach:
This approach uses more of short-term funds to finance even the permanent current assets.
The following chart gives a summary of the relative costs and benefits of the three different approaches: Factors | Hedging Approach | Conservative Approach | Aggressive Approach | Liquidity | Moderate | More | Less | Profitability | Moderate | Less | More |
The financing of working capital is of utmost important. What portion of current assets should be financed by current liabilities? What portion should be financed by long-term resources? Decisions on these questions will determine the financing mix.
Approaches to financing mix:
There are 3 basic approaches to determine an appropriate financing mix. They are a. Hedging or Matching approach. b. Conservative approach. c. Trade-off between the above two. a. Hedging approach:
The term hedging can be said to refer to a process of matching maturities of debt with the maturities of financial needs. According to this approach, the maturity of the sources of funds should match the nature of the assets to be financed. For the purpose of analysis, the assets can be broadly classified into two classes:
1. Those assets which are required in a certain amount for a given level of operation and hence do not vary over time 2. Those assets which fluctuate over time
The hedging approach suggests that the long-term funds should be used to finance the fixed portion of current assets requirements. Purely temporary requirements, i.e., the seasonal variations over and above the permanent financing needs should be appropriately financed with short-term funds. b. Conservative approach:
This approach suggests that the estimated requirements of total funds should be met from long-term sources; the use of short-term funds should be restricted to only emergency situations or when there is an unexpected outflow of funds. c. Aggressive approach:
This approach uses more of short-term funds to finance even the permanent current assets.
The following chart gives a summary of the relative costs and benefits of the three different approaches: Factors | Hedging Approach | Conservative Approach | Aggressive Approach | Liquidity | Moderate | More | Less | Profitability | Moderate | Less | More |