Three basic strategies are used in financing working capital. They differ in the proportion of long-term and short-term financing used as a source for permanent and temporary working capital. Moreover, these three approaches have different risk and profitability trade-off. They are:
Short-term interest rates are mostly lower than long-term rates. Therefore, using short-term financing helps reduce interest payments. Using long-term borrowing in financing working capital leads to higher interest payments compared with short-term borrowing. Moreover, financing of temporary working capital by long-term borrowing results in paying interest even when funds are not used.
Two risks are inherent in short-term financing:
Refinancing risk refers to the probability that a business will fail to replace an existing short-term loan with a new one, which can lead, for example, to a disruption in supplies, cessation of production, or a decrease in sales. The interest rate risk refers to the chance that a new loan will have a higher interest rate than a previous one, resulting in increased interest expense and reduced profitability.
Using long-term financing accepts the refinancing risk, but the interest rate risk still remains. If interest rates decline, businesses will incur higher interest expense because of a fixed interest rate on long-term borrowing.
An aggressive approach is most risky among working capital financing strategies. It doesn’t assume to hold any reserves to cover spontaneous needs in working capital. It means that only some portion of permanent working capital is financed by long-term financing. The rest and the temporary working capital, including seasonal fluctuations, are met by short-term borrowing. Adopting this approach makes it possible to reduce interest expense and increase profitability of a business, but it also carries the greatest risk.
Long-term Financing = Noncurrent Assets + Portion of Permanent Working Capital
Short-term Financing = Portion of Permanent Working Capital + Temporary Working Capital
The main drawback of an aggressive approach is that businesses need to access short-term borrowing frequently to recover both the portion of permanent working capital and temporary working capital. As a result, the exposure to refinancing risk increases sharply, and businesses become vulnerable to any interruption in accessing short-term borrowing.
The advantage of this working capital financing strategy is that short-term financing is mostly cheaper compared with long-term financing, which allows a reduction in interest expense. Such an approach, however, violates the matching principle, which states that noncurrent assets and permanent working capital should be financed by long-term financing.
A moderate approach, which is also called hedging strategy, follows the matching principle. According to this approach, noncurrent assets should be financed by long-term financing and current assets by short-term financing. Therefore, under a moderate approach, businesses should use long-term financing to finance noncurrent assets and permanent working capital. The need for temporary working capital should be met by short-term financing.
Long-term financing = Noncurrent Assets + Permanent Working Capital
Short-term financing = Temporary Working Capital
A moderate approach is a trade-off between an aggressive and a conservative approach. It has lower reinvestment and interest rate risk compared with an aggressive approach because short-term financing is only used to fund temporary working capital. It also has lower profitability, however, because of higher interest expense due to a higher proportion of long-term financing used to fund permanent working capital.
A conservative approach has the lowest risk and lowest profitability among other working capital financing strategies. Businesses use long-term financing to fund not only noncurrent assets and permanent working capital but also some portion of temporary working capital. This approach is also inherent in low liquidity risk because of excessive cash.
Under a conservative approach, even a portion of temporary working capital is covered by long-term financing, and only an emerging need for funds is met by short-term financing. It also happens that businesses have an excessive cash balance, which should be invested in marketable securities. Such investments are able to be sold at any time to cover the emerging need for working capital.
Long-term financing = Noncurrent Assets + Permanent Working Capital + Part of Temporary Working Capital
Short-term financing = Part of Temporary Working Capital
The advantages of a conservative approach are the lowest reinvestment and interest rate risk among the other working capital financing strategies. Moreover, it results in a higher level of liquidity and solvency, so such businesses can easily access short-term borrowing to cover emerging needs in working capital.
Lowest risk, however, also results in lowest profitability because long-term financing usually has a higher cost than short-term financing. Funding temporary working capital by long-term financing also leads to the fact that businesses have interest expenses even when they do not have any need for temporary working capital.