June 1st, 2008
For a firm, it can exercise a few options/policies when considering the risk return aspect when managing its working capital.
The following describe the different policies:
(1) MATCHING OR HEDGING APPROACH/POLICY
- This approach or policy is a moderate policy that matches assets and liabilities to maturities.
- Basically, a firm uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets
- A fixed asset/equipment which is expected to provide cash flow for 8 years should be financed by say 8 years long-term debts
- Assuming a firm needs to have additional inventories for 2 months, it will then sought short term 2 months bank credit to match it.
(2) CONSERVATIVE APPROACH/POLICY
- Conservative because the firm prefers to have more cash on hands
- Fixed and part of current assets are financed by long-term or permanent funds
- As permanent or long-term sources are more expensive, this leads to “lower risk lower return”
- Having excess cash at off-peak period hence the need to invest the idle or excess cash to earn returns.
(3) AGGRESSIVE APROACH/POLICY
- The firm want to take high risk where short term funds are used to a very high degree to finance current and even fixed assets