Aggressive Approach to Working Capital Financing

Aggressive approach is a high risk strategy of working capital financing wherein short term finances are utilized
not only to finance the temporary working capital but also a reasonable part of permanent working capital. In this
approach of financing, the levels of inventory, accounts receivables and bank balances are just sufficient with no
cushion for uncertainty. There is a reasonable dependence on the trade credit.
Fixed assets and a part of permanent working capital is financed by long term financing sources and the
remaining part of permanent working capital and total temporary working capital is only is financed by short term
financing sources. It is explained in the equation below:
Financing
Strategy
in
Equation:
Long Term Funds will Finance = Fixed Assets + Part of Permanent Working Capital
Short Term Funds will Finance = Remaining Part of Permanent Working Capital + Temporary Working Capital
Aggressive
Approach
Diagram:
For better and clear understanding, following diagram is utilized. The dotted lines horizontal line indicates the
point till which the long term funds will be utilized. The dotted vertical lines indicate the sources of finance and
they are tagged as long term financing and short term financing.

We can easily make out

that long term funds are financing total fixed assets and a part of permanent assets. Major part of Seasonal
requirement or temporary working capital is financed by short term source of finance. In this approach, the
difficult area is the part of permanent working capital which is financed by short term sources. It can pose
problems of liquidity and bankruptcy to the firm.
Advantages of Aggressive Strategy of Working Capital Financing
Lower Financing Cost, High Profitability: In this strategy, the cost of interest is low because of the
maximum usage of short term finances. There are two reasons of this. Firstly, the rate of interest is cheaper and
secondly, in the off seasons, the loan can be repaid and hence, no idle funds. If the operating cycle is moving
smoothly, it is called most effective working capital management.
Lower Carrying and Handling Cost:Lower level of inventory makes the carrying and holding cost also go down
and that directly affect the profitability.
Highly Efficient Working Capital Management: The task of working capital manager is to smoothly
run the operating cycle of the company with lowest level of working capital. Precisely, that is what this strategy is
all about. If the strategy is successful with no dissatisfied stakeholders, there is nothing better than this.
Disadvantages of Conservative Strategy of Working Capital Financing

Insolvency Risk: This strategy faces high level of insolvency risk because the permanent assets are financed
by the short term financing sources. To maintain those permanent assets, the firm would need repeated
refinancing and renewals. It is not necessary that all the time the refinancing is smooth. For any reason, if the
financial institution rejects the renewal, the firm will not be in a position to maintain those permanent assets and
will have to forcibly sell them. If failed in realizing those assets, the option left is liquidation. Liquidating the
permanent working capital is very difficult as it consists of accounts receivables and inventory.
Lost Opportunities and Unexpected Shocks: Since, there are no cushions or margin in this strategy of
financing, sudden big contracts of sales are not possible to execute. On the other hand, if there are other
uncertainties like delay in abnormal raw material acquisition, machinery break downs etc, the firm will disturb the
business operating cycle and therefore will face sustainability problems

Conservative Approach to Working Capital Financing

Conservative approach is a risk free strategy of working capital financing. A company adopting this
strategy maintains higher level of current assets and therefore higher working capital also. The major part of the
working capital is financed by the long term sources of funds such as equity, debentures, term loans etc. So, the
risk associated with short term financing is abolished to a great extent.
In conservative approach, fixed assets, permanent working capital and a part of temporary working capital is
financed by long term financing sources and the remaining part only is financed by short term financing sources.
Thus, the primaryobjective of working capital management is ensured. It is explained in the equation
below:
Financing
Strategy
in
Equation:
Long Term Funds will Finance = Fixed Assets + Permanent Working Capital + Part of Temporary Working Capital
Short Term Funds will Finance = Remaining Part of Temporary Working Capital
Conservative
Approach
Diagram:
To explain the approach with more clarity, let us use the following diagram. The dotted lines horizontal line
indicates the point till which the long term funds will be utilized. The dotted vertical lines indicate the sources of
finance and they are tagged as long term financing and short term financing.
We can easily make out that long term funds are financing total fixed assets, total permanent assets and a part of
the temporary or seasonal working capital also. Seasonal requirement or temporary working capital has peaks
and troughs. The two areas of troughs below the long term financing line indicate that there are idle long term
funds incurring unnecessary interest cost.

Advantages of Conservative Strategy of Working Capital Financing

Smooth Operations with No Stoppages: In this strategy, the level of working capital and current assets
(inventory, accounts receivables and most importantly liquid cash or bank balance) is high. Higher level of
inventory absorbs the sudden spurt in product sales, production plans, any abnormal delay in procurement time
etc. This achieves higher level of customer satisfaction and smooth operations of the company. Higher levels of
accounts receivables are due to relaxed credit terms which in turn attracts more customer and thereby higher
sales and higher sales means higher profits in normal circumstances.
No Insolvency Risk: Most important part and highly relevant to financing strategy is the higher levels of cash
and working capital. Higher working capital avoids the risk of refinancing which exists in case it is financed by
short term sources of finance. Not only the risk of refinancing but also the risk of adverse change in the interest
rate while getting the short term loans renewed are avoided. This is how the insolvency risk is avoided as at any
time company has sufficient capital to pay off any liability.
Disadvantages of Conservative Strategy of Working Capital Financing
Higher Interest Cost: This strategy employs long term sources of finance and hence there are all the
chances that the rate of interest will be high. The theory of term premium says that the long term funds have
higher interest rate compared to short term funds as risk perception and uncertainty is high in case of longer
terms.
Idle Funds: Long term loans cannot be paid off when wished and if paid cannot be easily availed back. As we
noted in the diagram, the long term funds remain unutilized in the times when seasonal spurt in activity is not
there. Idle funds have opportunity cost of interest attached to it.
Higher Carrying Cost: Higher level of inventory and debtors implies higher carrying and holding cost which
has direct impact on profitability.
Inefficient Working Capital Management: If the margins of the firm are low for a particular year, a
reasonable part of it will be attributed to working capital management. In such a situation, conservative approach
of financing may be called with other name of inefficient working capital management.

Maturity Matching or Hedging Approach to Working Capital

Financing
Maturity matching or hedging approach is a strategy of working capital financing wherein short term requirements
are met with short term debts and long term requirements with long term debts. The underlying principal is that
each asset should be compensated with a debt instrument having almost the same maturity.
Maturity Matching or Hedging Approach Equation
This matching approach of working capital financing can be explained in terms of a simple equation as follows
Long Term Funds will Finance = Fixed Assets + Permanent Working Capital
Short Term Funds will Finance = Temporary Working Capital
In the equations, long term funds are matched to long term assets and vice versa.
Hedging
or
Maturity
Matching
Approach
Diagram
these concepts are best understood with the help of a diagram. In the diagram, we can see three levels, each of
fixed assets, permanent working capital and temporary working capital. The red vertical line with white spaces
represents the type of financing. The bigger line which stretches till permanent working capital is long term
financing and smaller line is the temporary working capital. The line from where the temporary working capital
starts and the line of hedging strategy is the same. Any strategy below this line will be an aggressive strategy and
a
strategy
above
it
will
be
a
conservative
strategy.

RATIONALE BEHIND MATURITY MATCHING OR HEDGING APPROACH

Knowing why to apply maturity matching strategy is very important. It suggests financing permanent assets with
long term financing and temporary with short term financing. Now let us suppose opposite situations and see.
There can two such situations.
A. Permanent Assets Financed with Short Term Financing: In this situation, the borrower has to renew or
refinance the short term loan every time simply because the duration for which money is required is higher, say 3
years, than the available loan is of, say 6 months only. The firm needs to renew the loan 6 times. This firm is
exposed to refinancing risk.
If the lender for any reason denies for renewal, what will the firm do? In such a situation for paying off the loan,
either the firm will sell the permanent assets which effectively means closing the business or file for bankruptcy.

B. Temporary Assets Financed with Long Term Financing: In this situation, firstly, the borrower has
to pay interest on long term loans for those period also when the loan is not getting utilized. Secondly, the interest
rate of long term loans is normally dearer to short term loans due to the concept of term premium. These two
additional costs hit the profitability of the firm.
After all the discussion, in situation A, we learned that costs may be low but risk is too high and situation B
concludes high with low risk. Situation A is not acceptable because of such a high risk and situation B hits the
profitability which is primary goal of doing business and basis of survival. Therefore, the hedging or matching
maturity approach to finance is ideal for effective working capital management.