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Working Capital Management Maturity Matching orHedging Approach to Working Capital Financing

Sanjay Borad May 1, 2014 Working Capital Financing 0 Comments

Maturity matching or hedging approach is a strategyof working capital financing wherein short termrequirements are met with short term debts and longterm requirements with long term debts. Theunderlying principal is that each asset should becompensated with a debt instrument having almostthe same maturity.

Maturity Matching or Hedging Approach Equation

This matching approach of working capital financingcan be explained in terms of a simple equation asfollows

Long Term Funds will Finance = Fixed Assets + Permanent Working Capital

Short Term Funds will Finance = Temporary Working Capital

In the equations, long term funds are matched to long term assets and vice versa.

Hedging or Maturity Matching Approach DiagramThese concepts are best understood with the help of a diagram. In the diagram, we can see threelevels, each of fixed assets, permanent working capital and temporary working capital. The red verticalline with white spaces represents the type of financing. The bigger line which stretches till permanentworking capital is long term financing and smaller line is the temporary working capital. The line fromwhere the temporary working capital starts and the line of hedging strategy is the same. Any strategybelow this line will be an aggressive strategy and a strategy above it will be a conservative strategy.

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SEE ALSO

GLOBAL MUTUAL FUNDS

MORTGAGE INTEREST RATES

DEBT CONSOLIDATION CARE

ANGEL INVESTORS

CAPITAL PRIVATE EQUITY

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Working Capital Management Maturity Matching or Hedging Approach to Working Capital Financing Graph

RATIONALE BEHIND MATURITY MATCHING OR HEDGING APPROACH

Knowing why to apply maturity matching strategy is very important. It suggests financing permanentassets with long term financing and temporary with short term financing. Now let us suppose oppositesituations and see. There can two such situations.

A. Permanent Assets Financed with Short Term Financing: In this situation, the borrower has torenew or refinance the short term loan every time simply because the duration for which money isrequired is higher, say 3 years, than the available loan is of, say 6 months only. The firm needs torenew the loan 6 times. This firm is exposed to refinancing risk.

If the lender for any reason denies for renewal, what will the firm do? In such a situation for paying offthe loan, either the firm will sell the permanent assets which effectively means closing the business orfile for bankruptcy.

B. Temporary Assets Financed with Long Term Financing: In this situation, firstly, the borrowerhas to pay interest on long term loans for those period also when the loan is not getting utilized.Secondly, the interest rate of long term loans is normally dearer to short term loans due to theconcept of term premium. These two additional costs hit the profitability of the firm.

After all the discussion, in situation A, we learned that costs may be low but risk is too high andsituation B concludes high with low risk. Situation A is not acceptable because of such a high risk andsituation B hits the profitability which is primary goal of doing business and basis of survival.Therefore, the hedging or matching maturity approach to finance is ideal for effective working capitalmanagement.

You may also like:Drawing PowerPacking CreditObjectives of Working Capital ManagementWorking Capital Policy Relaxed, Restricted and ModerateCompare 3 Strategies of Working Capital Financing Maturity Matching

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