Hedging Approach To Working Capital

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Basically, the hedging principle is one which guides a firm’s debt maturity financing decisions.  The hedging principle states that the financing maturity should follow the cash flow characteristics of the assets being financed.  For example, as asset that is expected to provide cash flows over a period of say, 5 years, then it should be finance with a debt having similar pattern of cash flow requirements.  The hedging approach involves matching the cash flows generating characteristics of an asset with the maturity of the sources of financing used to finance it.

The hedging approach to working capital financing is based upon the concept of bifurcation of total working capital needs into permanent working capital and temporary working capital.  As the name itself suggests, the life duration of current assets and the maturity period of the sources of funds are matched.  The general rule is that the length of the finance should match with the life duration of the assets.  That is why the fixed assets are always financed by long term sources only.  So, the permanent working capital needs are financed by long term sources.  On the other hand, the temporary working capital needs are financed by short term sources only.  In other words, the core or fixed working capital is financed by long term sources of funds while the additional or fluctuating working capital needs the financed by the short term sources. 

For example, a seasonal expansion in inventories should be financed with short term loan or liabilities.  The rationale of the hedging principle is straight forward.  Funds are needed for a limited period say for purchase of additional inventory, and when that period is over, the cash needed to repay the loan will be generated by the sale of extra inventory items.  Obtaining the needed funds from a long terms source would mean that the firm would still have the fund after the inventories had already been sold.  In this case, the firm would have excess liquidity, which it either holds in cash or marketable securities until the seasonal increase in inventories occurs again.  The result of all this would be lowers the profits of the firm.  The financing mix as suggested by the hedging approach is a desirable financing pattern.  However, it may be noted that the exact match of maturity period of current assets and sources of finance is always not possible because of uncertainty involved.

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