kamlesh's Spot Follow

The other important question in respect of working capital is how to raise it. Traditionally, only short term sources are used to raise finance for working capital. But while analyzing the question of working capital, it seems the question is of raising working capital either from short-term sources or partly from long-term sources and partly from long-term sources.

Thus the question of financing working capital has two aspects:

(1) The sources of from which it can be raised.

(2) The short-term sources of working capital.

An important decision relating to working capital management is the sources from which working capital is to be raised. Generally, it is believed that funds for acquiring fixed assets should be raised from long-term sources and short-terms sources should be utilized for raising working capital. But in the recent diJustify Fullscussion on working capital, it is classified into Permanent Working Capital Variable or Fluctuating Working Capital. Therefore for raising permanent working capital, long-term sources should also be utilized. Thus both the types of sources may be utilized for financing both fixed assets and current assets.

There are different approaches for determining the proportion in which short-term and long-term sources should be used to finance fixed assets and current assets. There are three such approaches:

(1) Hedging Approach or Matching Approach (2) Conservative Approach (3) Aggressive Approach.

(1) Hedging Approach: The maturity of the source of funds is matched with the life of the asset. Funds for acquiring an asset having an estimated life of 5 years should be raised by a 5 year loan from the bank. If goods are expected to be sold within 30 days, then finance is obtained by a bill payable for 30 days.

Under this approach, funds for acquiring fixed assets and permanent current assets should be acquired with long-term funds like long-term loan or issue of debentures or equity shares. In traditional language, it can be said that fixed assets and permanent current assets should be financed by long-term funds and for temporary working capital short term funds should be used.

The above figure shows that for financing fixed assets and permanent current assets, long-term funds are used, while for variable current assets, short-term funds are utilized as and when necessary.’ Short term borrowings would be paid off with surplus cash. For expansion and development, when permanent financing is needed, it should be acquired from long-term sources only.

(2) Conservative Approach: This approach depends upon long-term funds to a great extent. It suggests that in addition to fixed assets and permanent current assets, even a part of variable current assets should also be financed from long-term sources. The short term sources are used only to meet the peak seasonal requirements. During off season, the surplus fund is kept-invested in marketable securities.

The figure shows the conservative approach indicating that for financing fixed assets, permanent current assets and for a part of variable current assets, funds are raised from long-term sources. Only for meeting peak period demand, short-term funds are raised. The element of risk is the minimum in this policy, because the maturity of long-term liability is known much in advance and provision can be made for its repayment. But the policy is expensive and reduces profitability.

(3) Aggressive Approach: This policy depends more on short-term funds. More short-tern funds are used particularly for variable current assets and a part of even permanent current assets; the funds are raised from short term sources.