Approaches to financing working capital requirements

A firm's working capital need has a permanent part, the minimum level of current assets always required, and a temporary part that rises and falls with the season. The approaches differ in how much of each is financed from long-term and from short-term sources.

1. Hedging (matching) approach. Maturities of the sources are matched with the duration of the needs: permanent working capital is financed from long-term funds, and temporary working capital from short-term funds. It keeps the cost of financing low, since short-term funds are paid for only while they are needed. But funds must be arranged frequently, and the firm is exposed if short-term credit is not renewed.

2. Conservative approach. The entire estimated investment in current assets is financed from long-term sources; short-term funds are used only for emergencies. Liquidity is higher and risk is minimised. The cost is relatively high, because interest is paid for the whole period even on seasonal needs, and funds lie idle in the off-season.

3. Aggressive approach. The entire estimated requirement of current assets is financed from short-term sources, and even part of the fixed assets may be financed short-term. The financing mix becomes more risky, less costly and more profitable.

4. Trade-off (moderate) approach. Hedging means low cost, high profit and high risk; the conservative approach means high cost, low profit and low risk. Neither extreme suits efficient working capital management, so a trade-off is adopted. One way is to finance the average of the maximum and minimum current-asset requirements from long-term funds, and the excess over that average from short-term funds.

Choice. The choice is a risk-return decision. The more short-term finance a firm uses, the lower its cost and the higher its profit, but the greater the risk of being unable to meet obligations when they fall due.