Hedging, conservative and trade-off approaches to financing working capital

The firm's working capital need has a permanent part, which is always present, and a temporary part, which rises and falls with the season. The approaches differ in how they finance the two parts with long-term and short-term funds.

1. Hedging (matching) approach. The maturity of the source of funds is matched with the nature of the asset it finances: permanent working capital is financed from long-term sources and temporary working capital from short-term sources.

• It keeps the cost of financing low, since short-term funds are borrowed only when they are needed.
• But the firm must keep arranging short-term funds, and it is exposed to sudden shocks, so the risk is higher.

2. Conservative approach. The entire estimated investment in current assets, permanent and temporary alike, is financed from long-term sources; short-term funds are used only for emergencies.

• Liquidity is higher and the risk is minimised; the firm does not face frequent financing problems and can absorb shocks.
• But the cost of financing is higher, as interest is paid on the seasonal requirement for the whole period, and funds lie idle in the off-season.

3. Trade-off (balancing) approach. Hedging gives low cost, high profit and high risk; the conservative approach gives high cost, low profit and low risk. Both are extremes, so a trade-off between them is the acceptable approach. One way is to find the average of the maximum and minimum requirements of current assets: the average is financed from long-term funds and the excess over it from short-term funds. The exact balance depends on how much risk the decision makers are willing to bear.