Working Capital Management Strategies/Approaches
There are broadly 3 working capital management strategies/ approaches to choose the mix of long and short term funds for financing the net working capital of a firm viz. Conservative, Aggressive, Hedging (Or Maturity Matching) approach. These strategies are different because of their different trade-off between risk and profitability. Another remarkable difference is the extent or proportion of application of long and short term fund to finance the working capital.
For equations, we will use the following abbreviations:
- FA = Fixed Assets
- PWC = Permanent Working Capital
- TWC = Temporary Working Capital
HEDGING (MATURITY MATCHING) STRATEGY
This is a meticulous strategy of financing the working capital with moderate risk and profitability. In this strategy, each of the assets would be financed by a debt instrument of almost the same maturity. It means if the asset is maturing after 30 days, the payment of the debt which has financed it will also have its due date of payment after almost 30 days. Hedging strategy works on the cardinal principle of financing i.e. utilizing long-term sources for financing long-term assets i.e. fixed assets and a part of permanent working capital and temporary working capital are financed by short-term sources of finance. Here, funds are applied as below and can be clearly seen in the above diagram.
- Long Term Funds will Finance- FA + PWC
- Short Term Funds will Finance- TWC
As the name suggests, it is a conservative strategy of financing the working capital with low risk and low profitability. In this strategy, apart from the fixed assets and permanent current assets, a part of temporary working capital is also financed by long-term financing sources. It has the lowest liquidity risk at the cost of higher interest outlay. Here, funds are applied as below and can be clearly seen in the above diagram.
- Long Term Funds will Finance- FA + PWC + Part of TWC
- Short Term Funds will Finance- Remaining Part of TWC
This strategy is the most aggressive strategy out of all the three. The complete focus of the strategy is in profitability. It is a high-risk high profitability strategy. In this strategy, the dearer funds i.e. long term funds are utilized only to finance fixed assets and a part of the permanent working capital. Complete temporary working capital and a part of permanent working capital also are financed by the short-term funds. It saves the interest cost at the cost of high risk. Here, funds are applied as below and can be clearly seen in the above diagram.
- Long Term Funds will Finance- FA + Part of PWC
- Short Term Funds will Finance- Remaining Part of PWC + TWC