Page 54 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 4: The Financing Mix

Notes
Example: The following example explains this approach.

Estimated Total Investment in Current Assets of Company X for the Year 2000

Month Investments in Permanent or Temporary or
Current Assets Fixed Investments Seasonal Investment
(`) (`) (`)
January 50,400 45,000 5,400
February 50,000 45,000 5,000
March 48,700 45,000 3,700
April 48,000 45,000 3,000
May 46,000 45,000 1,000
June 45,000 45,000 -------
July 47,500 45,000 2,500
August 48,000 45,000 3,000
September 49,500 45,000 4,500
October 50,700 45,000 5,700
November 52,000 45,000 7,000
December 48,500 45,000 3,500
Total 44,300

According to hedging approach the permanent portion of current assets required (` 45,000)
should be financed with long-term sources and temporary or seasonal requirements in different
months (` 5,400; ` 5,000 and so on) should be financed from short-term sources.

4.1.2 Conservative Approach

This approach suggests that the entire estimated investments in current assets should be financed
from long-term sources and the short-term sources should be used only for emergency
requirements. According to this approach, the entire estimated requirements of ` 52,000 in the
month of November (in the above given example) will be financed from long-term sources. The
short-term sources. The short-term funds will be used only to meet emergencies. The distinct
features of this approach are:

1. Liquidity is severally greater;
2. Risk is minimized; and
3. The cost of financing is relatively more as interest has to be paid even on seasonal
requirements for the entire period.

Did u know? What is trade-off between the hedging and conservative approaches?
The hedging approach implies low cost, high profit and high risk while the conservative
approach leads to high cost, low profits and low risk. Both the approaches are the two
extremes and neither of them serves the purpose of efficient working capital management.
A trade off between the two will then be an acceptable approach. The level of trade off may
differ from case to case depending upon the perception of risk by the persons involved in
financial decision-making. However, one way of determining the trade off is by finding
the average of maximum and the minimum requirements of current assets or working

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