Financing working capital requirements

Broadly speaking, there are two sources of financing working capital requirements, long term sources such as share capital, debentures, and public deposits etc. and short term sources such as commercial banks, indigenous banker, trade credits etc. therefore, a question arises as to what portion of working capital should be finances by long term sources and how much by short term sources.

There are three basis approaches for determining an appropriate working capital financing mix.

• The Hedging or matching Approach
• The conservative Approach
• The Aggressive Approach

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 finance 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. Hedging approach suggest 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 finances with short terms funds.

Conservative Approach This approach suggest that the entire estimate investments in current assets should be financed from long term sources and the short term sources should be used only for emergency requirements.

The Aggressive Approach The aggressive approach suggest that the entire estimated requirements of current 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.