3 Strategies of Working Capital Financing

There are three strategies or approaches or methods of working capital financing – Maturity Matching (Hedging), Conservative and Aggressive. Hedging approach is an ideal method of financing with moderate risk and profitability. Other two are extreme strategies. Conservative approach is highly conservative with very low risk and therefore low profitability. An aggressive approach is highly aggressive having high risk and high profitability.

We will compare these three approaches on 6 parameters viz. liquidity, profitability, risk, asset utilization, and working capital.

Factors Term Significance Conservative Aggressive Hedging
Liquidity It is extremely important in business for a smooth operation of the day to day business activities and to grab occasional opportunities thrown by the business. Liquidity is high, because of heavy usage of long-term funds. It can take advantage of sudden opportunities. Liquidity is low due to greater dependability on short-term funds even for a part of long-term assets. It does not keep idle funds and therefore saves interest cost on them. Liquidity is balanced i.e. neither high nor low. It attempts to strike a balance between liquidity and cost of idle funds.
Profitability Profitability is the final goal of any business. Each and every step of a manager should finally boil down to profitability. Under normal circumstances, profitability is less in this strategy because of too much of idle and costly funds. Higher rate and bigger magnitude of interest cost reduce the profitability. Since the interest cost is minimized in this approach, higher profitability is obtained. Because of cut to cut management, a balance is achieved between interest cost and loss of profitability. Moderate profitability is maintained here. It is greater than conservative and lesser than aggressive.
 
Risk Risk here refers to the risk of bankruptcy. There is very low risk of bankruptcy as a higher level of liquidity is maintained in the business in this approach. There is a high risk of bankruptcy due to extremely tight liquidity position being maintained. Risk is balanced here. The firm will bow down to bankruptcy only in an extremely bad situation.
Asset utilization Asset utilization here is the utilization of current assets. Too high level of current assets makes its utilization ratio low. Similarly, too low level of current assets makes the utilization ratio high. Moderate
Working capital Working capital is the capital used to fill the gap between current assets and current liabilities. More working capital is required to execute the conservatism. Higher working capital avoids all risks. Very low working capital is maintained. Low working capital increases risk but saves the interest cost. Moderate working capital is maintained to stay somewhere between conservative and aggressive strategies.

Last updated on : May 17th, 2014
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2 Comments

  1. blessing chiwundura
  2. satish

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