FINANCING WORKING CAPITAL
The financing of working capital is of utmost important. What portion of current assets should
be financed by current liabilities? What portion should be financed by long-term resources?
Decisions on these questions will determine the financing mix.
Approaches to financing mix:
There are 3 basic approaches to determine an appropriate financing mix. They are
a. Hedging or Matching approach.
b. Conservative approach.
c. Trade-off between the above two.
a. Hedging approach:
The term hedging can be said to refer to a process of matching maturities of debt with the
maturities of financial needs. According to this approach, the maturity of the sources of
funds should match the nature of the assets to be financed. For the purpose of analysis, the
assets can be broadly classified into two classes:
1. Those assets which are required in a certain amount for a given level of operation
and hence do not vary over time
2. Those assets which fluctuate over time
The hedging approach suggests that the long-term funds should be used to finance the fixed
portion of current assets requirements. Purely temporary requirements, i.e., the seasonal
variations over and above the permanent financing needs should be appropriately financed
with short-term funds.
b. Conservative approach:
This approach suggests that the estimated requirements of total funds should be met from
long-term sources; the use of short-term funds should be restricted to only emergency
situations or when there is an unexpected outflow of funds.
c. Aggressive approach:
This approach uses more of short-term funds to finance even the permanent current assets.
The following chart gives a summary of the relative costs and benefits of the three different
approaches:
Hedging
Approach
Liquidity
Moderate
Profitability Moderate
Risk
Moderate
Factors
Conservative
Approach
More
Less
Less
Aggressive
Approach
Less
More
More
The risk preferences of the management shall decide the approach to be adopted. The risk-neutral
will adopt the hedging approach, the risk averse the conservative approach and the risk seekers will
adopt the aggressive approach.
Debt Vs Equity
Debt financing involves both short-term debt and long-term debt and equity financing involves
only long-term financing. The financing mix of the working capital depends upon the risk preferences
of the management. Cost of different type of funds, the long-term and short-term, the return on
different type of current assets, risk-bearing ability of the concern, liquidity, levels etc., have to be
considered to decide the financing of working capital.
Debt financing involves fixed interest rates and allowed as an expense for tax purposes. But
the risk involved in debt-financing is also high as the company is liable to pay the fixed interest
periodically. Whereas in equity financing, the risk is comparatively lower than debt financing because
there is no fixed obligation on the part of the company to pay periodically their dividends. If the
company has sufficient profits, they can decide to pay dividends. They may even decide to retain
their earnings to finance future requirements. But the cost of financing through equity would be
higher as they are not allowed as an expense for tax purposes.
Companies adopting hedging approach would optimally use long-term funds to finance fixed
portion of current assets requirement. In manufacturing companies there may be requirement to
always maintain some amount of inventory in raw materials or finished goods to ensure smooth
production and business. This fixed portion of current assets may be financed through either debt or
equity after evaluating the costs of both types of financing. Whereas, other temporary current assets
may be financed through current liabilities or short-term funds like bank-overdraft, short-term loans,
accounts payable etc.
Companies adopting aggressive approach may finance even the fixed portion of their current
assets through short-term funds or may take risk by financing through accounts or notes payables.
Companies adopting conservative approach will take less risk and finance even their temporary
portion of current assets through long-term sources of finance and especially equity to lesser the
risk. Thus, we can say that the risk preference of the company management decides the financing
mix of working capital.
SOURCE:
http://www.tutorsonnet.com/homework_help/working_capital_management/debt_vs_equity_
online_tutoring.htm