Page 53 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes 4.1 Approaches to Determine an Appropriate Financing Mix

One of the most important decisions to be involved in the management of working capital is
determining the financing mix.

Broadly speaking, there are two sources of financing working capital requirements:
1. Long-term sources such as share capital, debentures, public deposits, ploughing back of
profits, loans from financial institutions, and

2. Short-term sources such as commercial banks, indigenous bankers, trade credits, installment
credit, advances, account receivables and so on. Therefore, a question arises as to what
portion of working capital (current assets) should be financed by long-term sources and
how much by short-term sources?

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

Figure 4.1: Basic Approaches to Financing Mix

Approaches to Financing Mix

The Hedging or The Conservative The Aggressive
Matching Approach Approach Approach

4.1.1 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:
1. Permanent or fixed working capital which is the minimum amount required to carry out
the normal business operations. It does not vary over time.
2. 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.

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