DETERMINING FINANCING MIX
Apart from the profitability risk trade off, another important ingredient of the theory of working capital management is determining the financing mix. One of the most important decisions, in other words, involved in the management of working capital is how current assets will be financed. There are, broadly speaking, two sources from which funds can be raised for current asset financing; (i) short term sources (current liabilities), and (ii) long term sources, such as share capital, long term borrowings, internally generated resources like retained earnings and so on. What proportion of current assets should be financed by current liabilities and how much by long term resources? Decisions on such questions will determine the financing mix.
The term hedging is often used in the sense of a risk reducing investment strategy involving transactions of a simultaneous but opposing nature so that the effect of one is likely to counterbalance the effect of the other. With reference to an appropriate financing mix, the term hedging can be said to refer to the process of matching maturities of debt with the maturities of financial needs. This approach to the financing decision to determine an appropriate financing mix is, therefore, also called as matching approach.
According to this approach, the maturity of the source of funds should match the nature of the assets to be financed. For the purpose of analysis, the current assets can be broadly classified into two classes:
1. those which are required in a certain amount for a given level of operation and, hence, do not vary over time.
2. those which fluctuate over time.
The hedging approach suggests that long term funds should be used to finance the fixed portion of current assets requirements as spelt out in (1) above, in a manner similar to financing of fixed assets, The purely temporary requirements, that is, the seasonal variations over and above the permanent financing needs should be appropriately financed with short term fund (current liabilities). This approach, therefore, divides the requirements of total funds into permanent and seasonal components, each being financed by a different source.
Estimated Total Funds Requirements of Hypothetical Ltd