WORKING CAPITAL MANAGEMENT

Meaning
Capital required for a business may be classified into two
main categories:
(i) Fixed capital and
(ii) Working capital
Every business needs funds for two purposes – for its
establishment and to carry out it’s day-to-day operations.
Long term funds are required to create production facilities
through purchase of fixed assets such as plant and
machinery, land, buildings, furniture etc. Investments in
these assets represent fixed capital.
Funds are also needed for short-term purposes for the
purchase of raw materials, payment of wages and other
day-to-day expenses etc. These funds are known as working
capital.
Thus, working capital refers to that part of the firm’s capital
which is required for financing short term or current assets
such as cash, marketable securities, debtors, inventories
etc. Fund, thus, invested in current assets keep revolving
fast and are being constantly converted into cash and this
cash flows out again in exchange for other current assets.
Hence, it is also known as revolving or circulating capital or
short-term capital.

1
Concepts of Working Capital
There are two concepts of working capital – gross and net.
Gross Working Capital
Gross Working Capital refers to the firm’s investment in
current assets. Current assets are the assets which can be
converted into cash within an accounting year.
Constituents of current assets

✔ Cash in hand and bank balances

✔ Bills receivables

✔ Sundry debtors (less Provision for bad and

doubtful debts)

✔ Short term loans and advances

✔ Inventories of stocks (Raw materials, work-in-

progress, stores and spares, finished stock)

✔ Temporary investments of surplus funds

Net Working Capital

Net Working Capital refers to the difference between
current assets and current liabilities.
Current liabilities are those claims of outsiders which are
expected to mature for payment within an accounting year.

2
Constituents of current liabilities

✔ Bills payable

✔ Sundry creditors or accounts payable

✔ Accrued or outstanding expenses

✔ Short-term loans

✔ Dividends payable

✔ Bank overdraft

✔ Provision for taxation

Net working capital can be positive or negative.
A positive net working capital will arise when current
assets exceed current liabilities. A negative net
working capital occurs when current liabilities are in
excess of current assets.

Focusing on Current Assets Management

The gross working capital concept focuses on attention
of two aspects of current assets management:
(i) How to optimise investment in current assets?
(ii) How should current assets be financed?
The consideration of the level of investment in current
assets should avoid two danger points – excessive and
3
inadequate investment in current assets. Investment in
current assets should be just adequate to the needs of
the business firm. Excessive investment in current
assets should be avoided because it impairs the firm’s
profitability, as idle investment earns nothing.
On the other hand, inadequate amount of working
capital can threaten the solvency of the firm because of
its inability to meet its current obligations.
Another aspect of the gross working capital points to
the need of arranging funds to finance current assets.
Whenever a need for working capital arises due to the
increasing level of business activity or for any other
reason, financing arrangements should be made
quickly.
Focusing on Liquidity Management
Net working capital is a qualitative concept. It indicates
the liquidity position of the firm and suggests the extent
to which the working capital needs may be financed by
permanent source of funds. Current assets should be
sufficiently in excess of current liabilities to constitute a
margin or buffer for maturing obligations, within the
operating cycle of a business.
In order to protect their interests, short-term creditors
always like a company to maintain current assets at a
higher level than current liabilities.

4
The net working capital concept also covers the
question of judicious mix of long-term and short-term
funds for financing the current assets. For every firm,
there is a minimum amount of net working capital which
is permanent. Therefore, a portion of working capital
should be financed with the permanent source of funds
such as equity share capital, debentures, long-term
debt, preference share capital etc.
Operating cycle or Circulating Flow Concept
The circular flow of working capital is based upon the
Operating cycle or working capital cycle of a firm. The
cycle starts with the purchase of raw material and other
resources and ends with the realisation of cash from the
sale of finished goods. It involves purchase of raw
materials and store, its conversion into stock of finished
goods through working in progress with progressive
increment of labour and service costs, conversion of
finished goods into sales, debtors and receivables and
ultimately realisation of cash and this cycle continues
again from cash to purchase of raw materials and so on.
Operating cycle is the time duration required to covert
sales, after the conversion of resources into inventories,
into cash.
The operating cycle of a manufacturing company
involves three phases:

5
 ⮚ Acquisition of resources such as raw material,
labour, power, fuel etc.

⮚ Manufacturing of the product which includes

conversion of raw material into work-in-progress
into finished goods.

⮚ Sale of the product either for cash or on credit.

Credit sales create accounts receivable for
collection.
The speed/time duration required to complete one
cycle determines the requirements of working capital –
longer the period of cycle, larger is the requirement of
working capital.
The gross operating cycle of a firm is equal to the length
of inventories and receivables conversion periods. Thus,
Gross Operating Cycle = RMCP + WIPCP + FGCP + RCP
Where, RMCP = Raw Material Conversion Period
WIPCP = Work-in-progress Conversion Period
FGCP = Finished Goods Conversion Period
RCP = Receivables Conversion Period
However, a firm may acquire some resources on credit
and thus defer payments for certain period. In such

6
 case, net operating cycle period can be computed as
below:
Net Operating Cycle Period = Gross Operating Cycle
Period – Payable Deferral Period
The following are the formulae to determine the conversion
periods:
𝑅𝑎𝑤 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 𝑅𝑎𝑤 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙
=
𝑅𝑎𝑤 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝐷𝑎𝑦

𝑊𝑜𝑟𝑘 𝑖𝑛 𝑝𝑟𝑜𝑔𝑟𝑒𝑠𝑠 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 𝑊𝑜𝑟𝑘 𝑖𝑛 𝑝𝑟𝑜𝑔𝑟𝑒𝑠𝑠
=
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝐷𝑎𝑦

𝐹𝑖𝑛𝑖𝑠ℎ𝑒𝑑 𝐺𝑜𝑜𝑑𝑠 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 𝐹𝑖𝑛𝑖𝑠ℎ𝑒𝑑 𝐺𝑜𝑜𝑑𝑠
=
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑃𝑒𝑟 𝐷𝑎𝑦
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑟 𝐷𝑎𝑦
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑃𝑒𝑟 𝐷𝑎𝑦

Permanent and Variable Working Capital

On the basis of time, working capital may be classified into two types:

1. Permanent or fixed working capital

2. Temporary or variable working capital

1.Permanent or fixed Working Capital

Permanent or fixed Working Capital is the minimum amount which is required

to ensure effective utilisation of fixed facilities and for maintaining the

7
circulation of current assets. There is always a minimum level of current assets
which is continuously required by the enterprise to carry out its normal business
operations. For example, every firm has maintain a minimum level of raw
materials, work-in-process, finished goods and cash balance. This minimum level
of current assets is called permanent or fixed working capital as this part of
capital is permanently blocked in current assets.

As the business grows, the requirements of permanent working capital also

increase due to the increase in current assets.

2.Temporary or Variable Working Capital

Temporary or Variable Working Capital is the amount of working capital which

is required to meet the seasonal demands and some special exigencies.

Temporary working capital differs from permanent working capital in the sense
that it is required for short periods and cannot be permanently employed
gainfully in the business. The following diagram illustrates the difference
between permanent and temporary working capital.

Fig. 1
WORKING CAPITAL
AMOUNT OF

TEMPORARY OR VARIABLE WORKING CAPITAL

PERMENENT OR FIXED WORKING CAPITAL

TIME

41

8
 Fig. 2
TEMPORARY OR VARIABLE
WORKING CAPITAL
AMOUNT OF

PERMENENT OR FIXED
WORKING CAPITAL

TIME

42

In Fig. 1, permanent working capital is stable or fixed over time while the
temporary or variable working capital fluctuates. In Fig. 2, permanent working
is also increasing with the passage of time due to expansion of business but even
then it does not fluctuate as variable working capital which sometimes increases
and sometimes decreases.

Working capital is the life blood and nerve centres of a business. Just as the
circulation of blood is essential in the human body for maintaining life, working
capital is very essential to maintain the smooth running of a business.

Importance or advantages of adequate working capital

1. Solvency of the business

2. Goodwill
3. Easy loans
4. Cash discounts
5. Regular supply of raw materials
6. Regular payment of salaries, wages and other day-to-day commitments.
7. Exploitation of favourable market conditions
8. Ability to face crisis
9. Quick and regular return investments

9
 10. High morale.

Excess or inadequate working capital

Every business concern should have adequate working capital to run its business
operations. It should have neither redundant or excess working capital nor
inadequate or shortage of working capital. But excess as well as short working
capital position are bad for any business. However, out of the two, it the
inadequacy of working capital which is more dangerous from the point of view
of the firm.

Disadvantages of excessive working capital

1) Excessive working capital means idle funds which earn no profits.

2) Excessive working capital may lead to unnecessary purchasing and

accumulation of inventories causing more chances of theft, waste and
losses.

3) Excessive working capital implies excessive debtors and defective credit

policy which may cause higher incidence of bad debts.

4) It may result into overall inefficiency in the organization.

5) When excessive working capital, relations with the banks other financial
institutions may not be maintained.

6) Due to low rate of return on investments, the value of shares may also
fall.

7) The excessive working capital may cause speculative transactions.

Disadvantages or dangers of inadequate working capital

1) A concern which has inadequate working capital cannot pay its short-term
liabilities in time. Thus, it will lose its reputation and shall not be able to
get good credit facilities.

2) It cannot buy its requirements in bulk and cannot avail of discount etc.

3) It becomes difficult for the firm to exploit favourable market conditions

and undertake profitable projects due to lack of working capital.

10
 4) The firm cannot pay day-to-day expenses of its operations.

5) It becomes impossible to utilise efficiently the fixed assets due to non-

availability of liquid funds.

6) The rate of return on investments also falls with the shortage of working
capital.

Need or objectives of Working Capital

1) For the purchase of raw materials, components and spares.

2) To pay wages and salaries.

3) To incur day-to-day expenses and overhead costs such as fuel, power and
office expenses etc.

4) To meet the selling costs as packing, advertising etc.

5) To provide credit facilities to customers.

6) To maintain the inventories of raw materials, work-in-progress, stores and

spares and finished stock.

FACTORS DETERMINING THE WORKING CAPITAL

REQUIREMENTS/DETERMINANTS OF WORKING CAPITAL

There are no set rules or formulae to determine the working capital

requirements of firms. A large number of factors, each having a different
importance, influence the working capital needs of firms.

1. Nature or character of business

Working capital requirements of a firm are basically influenced by the nature of

its business. Trading and financial firms have a very small investment in fixed
assets, but requires a large sum of money to be invested in working capital.
Retail store, for example, must carry large stocks of a variety of goods to satisfy
varied and continuous demands of their customers. Some manufacturing
businesses such as tobacco manufacturers and construction firms, also have to
invest substantially in working capital and nominal amount in fixed assets. On
the other hand, public utilities may have limited need for working capital and
have to invest abundantly in fixed assets.
11
2. Size of business/scale of operations

The working capital requirements of a concern are directly influenced by the size
of its business which may be measured in terms of scale of operations. Greater
the size of a business unit, generally larger will be the requirement of working
capital.

3. Production policy

In certain industries the demand is subject to wide fluctuations due to seasonal

variations. The requirements of working capital, in such cases, depend upon the
production policy. The production could be kept either steady by accumulating
inventories during slack periods with a view to meet high demand during the
peak season or the production could be curtailed during the slack season and
increased during the peak season. If the policy is to keep production steady by
accumulating inventories it will require higher working capital.

4. Manufacturing process/Length of Production Cycle

In manufacturing business, the requirements of working capital increase in

direct proportion to length of manufacturing process. Longer the process period
of manufacture, larger is the amount of working capital required. The longer the
manufacturing time, the raw materials and other supplies have to be carried for
a longer period in the process with progressive increment of labour and service
costs before the finished product is finally obtained.

5. Seasonal variations

In certain industries, raw material is not available throughout the year. They
have to buy the raw materials in bulk during the season to ensure an
uninterrupted flow and process them during the entire year. A huge amount is,
thus, blocked in the form of material inventories during such season which gives
rise to more working capital requirements.

6. Working capital cycle

In a manufacturing concern, the working capital cycle starts with the purchase
of raw materials and ends with the realisation of cash from the sale of finished
products. The speed with which the working capital completes one cycle

12
determines the requirements of working capital – longer the period of cycle
larger is the requirement of working capital.

7. Rate of Stock Turnover

There is high degree of inverse relationship between the quantum of working

capital and the velocity or speed with which the sales are effected. A firm having
high rate of stock turnover will need lower amount of working capital as
compared to a firm having a low rate of turnover.

8. Credit policy

The credit policy of the firm affects the working capital by influencing the level
of debtors. A concern that purchases its requirements on credit and sells its
products/services on cash requires lesser amount of working capital. On the
other hand, a concern buying its requirements for cash and allowing credit to its
customers, shall need larger amount of working capital as very huge amount of
funds are bound to be tied up in debtors and bills receivables.

9. Business cycles

Business cycles refer to alternate expansion and contraction in general business

activity. In a period of boom, there is a need for a larger amount of working
capital due to increase in sales, rise in prices etc. On the contrary, in the times
of depression, difficulties are faced in collection from debtors and firms may
have larger amount of working capital lying idle.

10. Rate of growth of business

The working capital requirements of a concern increase with the growth and
expansion of its business activities. For normal rate of expansion in the volume
of business, we may have retained profits to provide for more working capital
but in fast growing concerns, we shall require larger amount of working capital.

11. Price Level Changes

The increasing shifts in price level make the functions of financial manager
difficult. He should anticipate the effect of price level changes on working capital
requirements of the firm. Generally, rising price levels will require firms to
maintain higher amount of working capital.

13
12. Earning capacity and Dividend Policy

Some firms have more earning capacity than others due to quality of their
products, monopoly conditions etc. Such firms with higher earning capacity may
generate cash profits from operations and contribute to their working capital.
The dividends policy of a concern also influences the requirements of its working
capital.

ISSUES IN WORKING CAPITAL MANAGEMENT

The financial manager must determine the level and composition of current
assets. He must see that right sources are tapped to finance current assets, and
that current liabilities are paid in time.

The following are the main aspects of working capital management which make
it important function of the financial manager:

● Time: working capital management requires much of financial manager’s

time;
● Investment: working capital represents a large portion of the total
investment in assets;
● Criticality: working capital management has great significance for all firms
but it is very critical for small firms; and
● Growth: the need for working capital is directly related to the firm’s
growth.

Current Assets to Fixed Assets Ratio

The level of current assets can be measured by relating current assets to fixed
assets. Dividing current assets by fixed assets gives CA/FA ratio. Assuming a
constant level of fixed assets, a higher CA/FA ration indicates a conservative
current assets policy and a lower CA/FA ratio means an aggressive current assets
policy, assuming other factors to be constant.

A conservative policy implies greater liquidity and lower risk; while an aggressive
policy indicates higher risk and poor liquidity. Moderate (Average) current assets
policy falls in the middle of conservative and aggressive policies. The various
working capital policies indicating the relationship between current assets and
output are depicted below:

14
 A Conservative
Level of Current Assets Policy

B Moderate
Policy

C
Aggressive
Policy
Fixed Assets Level

Output
Various Working Capital Policies

88

Liquidity vs. Profitability: Risk-return Trade-off

The firm would make just enough investment in current assets if it were possible
to estimate working capital needs exactly. Under perfect certainty, current
assets holdings would be at the minimum level. A larger investment in current
assets under certainty would mean a low rate of return on investment for the
firm, an excess investment in current assets will not earn enough return. A
smaller investment in current assets, on the other hand, would mean
interrupted production and sales, because of frequent stock-outs and inability
to pay to creditors in time due to restrictive policy.

As it is not possible to estimate working capital needs accurately, the firm must
decide about levels of current assets to be carried.

Given a firm’s technology and production policy, sales and demand conditions,
operative efficiency etc., its current assets holding will depend upon its working
capital policy. It may follow a conservative or an aggressive policy. These policies
involve return-return trade-offs. A conservative policy means lower return and
risk, while an aggressive policy produces high return and risk.

Profitability and Solvency

15
The two important aims of the working capital management are: profitability
and solvency.

Solvency refers to the firm’s continuous ability to meet maturing obligations.

Lenders and creditors expect prompt settlements of their claims as and when
due. To ensure solvency, the firm should be very liquid, which means larger
current assets holdings. If the firm maintains a relatively larger investment in
current assets, it will have no difficulty in paying claims of creditors when they
become due and will be able to fill all sales orders and ensure smooth
production.

Thus, a liquid firm has less risk of solvency; that is, it will hardly experience a
cash shortage or a stock-out situation. However, there is a cost associated with
maintaining a sound liquidity position. A considerable amount of the firm’s
funds will be tied up in current assets, and to the extent this investment is idle,
the firm’s profitability will suffer.

To have a higher profitability, the firm may sacrifice solvency and maintain a
relatively low level of current assets. When the firm does so, its profitability will
improve as fewer funds are tied up in idle current assets. But its solvency would
be threatened and would be exposed to greater risk of cash shortage and stock-
outs.

Costs of Liquidity and Illiquidity: Risk-return Trade-off

A different way of looking into the risk-return trade off is in terms of the cost of
maintaining a particular level of current assets. There are two types of costs
involved: cost of liquidity and cost of Illiquidity. If the firm’s level of current
assets is very high, it has excessive liquidity. Its return on assets will be low, as
funds tied up in idle cash and stocks earn nothing and high levels of debtors
reduce profitability. Thus, the cost of liquidity (though low rates of return)
increases with the level of current assets.

The cost of illiquidity is the cost of holding insufficient current assets. The firm
will not be in a position to honour its obligations if it carries too little cash. This
may force the firm to borrow at higher rates of interest. This will also adversely
affect the creditworthiness of the firm and its will face difficulties in obtaining

16
funds in the future. All this may force the firm into insolvency. Similarly, the low
level of stocks will result in loss of sales and customers may shift to competitors.

In determining the optimum level of current assets, the firm should balance the
profitability-solvency tangle by minimising total costs - cost of liquidity and cost
of illiquidity. This is shown in the following figure. In the figure, it is indicated
that with the level of current assets, the cost of liquidity increases while the cost
of illiquidity decreases and vice versa. The firm should maintain its current assets
at that level where the sum of these two costs is minimised. The minimum cost
point indicates the optimum level of current assets in the figure.

Total Cost
Minimum Cost
Cost

Cost of
Liquidity

Cost of
Illiquidity

Optimum Level of Level of Current Assets

Current Assets
Risk Return Trade off : Cost of Liquidity and Cost of Illiquidity 92

Methods for estimating/forecasting working capital requirements

There are three widely used methods for determining working capital
requirements of a firm:

1. Percentage of sales method

2. Regression analysis method

17
3. Operating cycle method

1. Percentage of sales method

In this method, level of working capital requirements is decided on the basis of

past experience. The past relationship between sales and working capital is
taken as a base for determining the size of working capital requirements for
future. It is, however, presumed that relationship between sales and working
capital, as existed in the past, has been stable.

This method is simple and easily understood and is practically used for
ascertaining short-term changes in working capital in the future. However, this
method lacks reliability in as much as its basic assumption of linear relationship
between sales and working capital does not hold true in all the cases.

2. Regression analysis method

This is statistical method of determining working capital requirements by

establishing the average relationship between sales and working capital and its
various components in the past years. In this regard, the method of least squares
is employed and the relationship between sales and working capital is expressed
by the equation:

Y = a + bx

Where, y = Working capital (dependent variable)

a = Intercept of the least square (fixed component)

b = Slope of the regression line (variable component)

x = Sales (independent variable)

For determining the values ‘a’ and ‘b,’ two normal equations are used which
can be solved simultaneously:

∑y = na + b∑x

∑xy = a∑x + b∑x2

3. Operating cycle method

18
This method of estimating working capital requirements is based upon the
operating cycle concept of working capital. The speed/time duration required
to complete one cycle determines the requirements of working capital – longer
the period of cycle, larger is the requirement of working capital.

The requirement of working capital can be estimated as follows:

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑦𝑐𝑙𝑒 (𝑑𝑎𝑦𝑠)
= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑥 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑐𝑎𝑠ℎ 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
365 𝑜𝑟 360 𝑑𝑎𝑦𝑠

Policies for financial current assets

A firm can adopt different financing policies vis-a-vis current assets. The
following are the three different types of financing:

Long term financing

The source of long term financing includes ordinary share capital, preference
share capital, and debentures, long-term borrowings from financial institutions
and reserves and surplus.

Short term financing

The short term financing is obtained for a period of less than one year. It is
arranged in advance from banks and other suppliers of short term finance in
the money market.

Spontaneous financing

Spontaneous financing refers to the automatic sources of short term funds

arising in the normal course of a business. Trade (suppliers) creditors and
outstanding expenses are examples of spontaneous financing. There is no
explicit cost of spontaneous financing.

What should be the mix of short and long term financing sources in financing
current assets?

Depending on the mix of short and long-term financing, the approach followed
by a company may be referred to as:

● Matching approach

19
 ● Conservative approach

● Aggressive approach

Matching approach

The firm can adopt a financial plan which matches the expected life of assets
with the expected life of the sources of funds raised to finance assets. Thus, a
ten year loan may be raised to finance a plant with an expected life of ten years;
stock of goods to be sold in thirty days may be financed with a thirty-day
commercial paper or a bank loan.

Financing long term assets with short term financing is costly as well as
inconvenient, as arrangements for the new short-term financing will have to be
made on a continuous basis. The matching approach is also known as hedging
approach.

Conservative approach

A firm may adopt a conservative approach in financing its current assets and
fixed assets. The financing policy of the firm is said to be conservative when it
depends more on long-term funds for financing needs. Under a conservative
plan, the firm finances its permanent assets and also a part of temporary current
assets with long-term financing.

Aggressive approach

A firm may be aggressive in financing its assets. An aggressive policy is said to

be followed by the firm when it uses more short-term financing than
warranted by the matching plan. Under an aggressive policy, the firm finances
a part its permanent current assets with short-term financing. Some extremely
aggressive firms may even finance a part of their fixed assets with short-term
financing.

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