Approaches for Financing Current Assets

Principle & Practice of Management

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Approaches for Financing Current Assets

Financing Current Assets

Once the estimation or determination of the financing current assets is over then the next step in working capital management is the financing current assets. There are three financing policies vis-a-vis to financing current assets. Adoption of the specific policy is left out to the firm. The three financing policies are:
1. Short-term Financing: Generally current assets should be financed by only short-term financial sources. Short-term finance is obtained for a period of less than one year. The sources of short-term finance are loans from banks, public deposits, commercial papers, factoring of receivables, bills discounting, retention of profits etc., a firm, which required
short-term finance, can go for any one of these sources. In other words, a firm that required short-term finance can raise through any one of the sources.
2. Long-term Financing: Net current assets or permanent current assets or working capital are supposed to be financed by long-term sources of finance. Long-term finance is raised for a period of more them five years. Long-term finance sources include ordinary share capital, preference share capital, debentures, long-term loans from bankers, and surpluses (includes retained earnings). A firm that needs to finance net current assets can go for any of these sources, but it depends on company’s attitude towards risk or control over the company, companies earnings, capacity and period of loan reserved.
3. Spontaneous Financing: It refers to the automatic sources of short-term funds arising in the normal course of a business. The source includes trade credit (suppliers’) and outstanding expenses. Spontaneous sources of finance are available at no cost. A firm that wishes to maximise owner’s wealth, it must and should utilise these sources to the fullest extent. The real choice of financing current assets is between short–term and long-term sources. In other words, some extent of current assets can be financed with the use of spontaneous source, and the requiring current assets should be financed with the combination of long-term and short-term sources of finance.

Financing Current Assets

Matching or Hedging Approach

The matching approach is that approach in which, the expected life of an asset is matched with the source of finance period with which an asset is financed. For example, an asset, which is having an expected life of 15 years, should be financed only through 15 years loan, or 15 years debentures, or 15 years redeemable preference shares. In other words, the life of an asset should match with the maturity of the source of funds. Hence, it is known as a matching approach. The term hedging is used in the sense of a risk-reducing investment strategy involving transactions of a simultaneous but opposing nature that counterbalance the effect of each other with reference to finance mix, the term hedging can be said to refer to the process of matching maturing of debt with the matching of financial needs. Fixed assets and permanent current assets should be financed by long-term funds and temporary current assets should be financed by short-term funds.

Conservative Approach

According to this approach, a firm depends more on long-term funds for financing needs. In this plan, the firm finances its regular or permanent current assets and a part of temporary or variable current assets with a long-term source of funds. In the year, when the firm has no need of funds for temporary current assets, the idle funds (long-term) can be invested in the marketable securities so that the firm conserves liquidity. Figure 14.3 shows the conservative policy.