Working capital financing choices - Cost and risk trade-offs

Learning Outcomes

After reading this article, you will be able to explain key working capital financing options and evaluate their cost and risk implications. You will distinguish between short-term and long-term finance for working capital, compare aggressive, conservative, and matching funding policies, and assess the impact of financing choices on liquidity, profitability, and risk. These are essential skills for ACCA FM exam success.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the strategies and considerations involved in funding working capital. In particular, you should be able to:

• Distinguish between permanent and fluctuating current assets and the funding implications.
• Evaluate the cost and risk associated with short-term versus long-term sources of finance.
• Explain the matching, aggressive, and conservative approaches to working capital funding.
• Assess the impact of working capital financing decisions on liquidity, profitability, and risk.
• Discuss the factors affecting the funding strategy, including management risk attitudes and firm size.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes a conservative working capital funding policy? a) Relying mainly on short-term finance for all current assets. b) Matching the maturity of finance to the type of current asset. c) Using mainly long-term finance, even for fluctuating current assets. d) Funding all working capital needs with bank overdrafts.
2. True or false? Short-term finance is usually cheaper than long-term finance but increases refinancing and liquidity risk.
3. What is the principal risk of an aggressive working capital funding policy?
4. Briefly describe the matching principle in working capital financing.

Introduction

Efficient working capital management ensures a business has the resources to operate smoothly without excessive cost or risk. A key decision is how to fund current assets—should the business rely on short-term or long-term finance? The chosen approach affects liquidity, profitability, and the firm's overall risk exposure.

You must be able to distinguish between types of working capital, understand the funding options available, and evaluate the advantages and risks associated with each. This article will guide you through the main financing policies, the important cost-versus-risk trade-offs, and help you prepare for exam scenarios involving working capital financing choices.

Key Term: permanent current assets
The minimum level of current assets required to support a business’s ongoing, day-to-day operations throughout the year. This is also known as “core” working capital.

Key Term: fluctuating current assets
The portion of current assets that grows and shrinks over time with seasonal or unexpected changes in activity or sales.

WORKING CAPITAL FUNDING STRATEGIES

Decisions about how to fund current assets can be grouped into three broad approaches:

• Matching (or hedging) policy
• Aggressive policy
• Conservative policy

The choice impacts both the cost of finance and the financial risk faced by the business.

1. The Matching Principle

The matching, or “hedging,” principle states that assets should be financed with liabilities of similar maturity. Permanent current assets and non-current assets should be funded with long-term finance, while only fluctuating current assets are funded with short-term finance. The aim is to align the timing of finance repayments with the cash flows from assets.

Key Term: matching principle
The practice of financing assets with sources of funds that have similar maturities to reduce refinancing and liquidity risk.

2. Aggressive Funding Policy

An aggressive policy uses a high proportion of short-term finance to fund even some permanent current assets. The motive is to reduce interest costs, since short-term borrowing usually has lower rates. However, this increases the risk of cash shortages, higher refinancing risk, and possible insolvency if sources of short-term finance become unavailable or unaffordable. Reliance on overdrafts or short-term loans is common.

3. Conservative Funding Policy

A conservative policy uses mainly long-term finance, even for part or all of the fluctuating current assets. This reduces the threat of refinancing problems and improves liquidity, but is more expensive due to higher long-term borrowing costs. This approach may result in surplus cash during low-activity periods, which should be invested carefully.

Comparison Table

Worked Example 1.1

A company requires at least $200,000 of inventory and receivables year-round (permanent current assets). However, due to seasonal peaks, extra current assets of $100,000 are needed for three months each year (fluctuating current assets). Describe how the matching, aggressive, and conservative policies would fund these assets.

Answer:

• Matching: $200,000 funded using long-term finance (e.g., term loan or equity); $100,000 funded by short-term finance (e.g., overdraft) for three months.
• Aggressive: Both the $200,000 and $100,000 (total $300,000) are funded by short-term finance—maximizing cost savings but accepting high rollover/refinancing risk.
• Conservative: All $300,000 is covered by long-term finance throughout the year, even if only $200,000 is needed most of the time—least risky but most expensive.

Cost and Risk Trade-Offs

The trade-off between cost and risk is central to funding choices:

• Short-term finance: Lower interest rates and often easier to arrange. Risk of not being able to refinance (“refinancing risk”) at maturity or facing sudden rate increases. Available sources include overdrafts, short-term loans, and trade credit.

• Long-term finance: Greater certainty and stability, but higher cost. Useful for funding permanent current assets and non-current assets. Includes term loans, bonds, and retained earnings.

Key Term: refinancing risk
The danger that a business will not be able to renew or replace short-term finance when it comes due, potentially resulting in cash flow problems or insolvency.

Worked Example 1.2

Juno Ltd funds all current assets with a revolving overdraft, as it is currently cheaper than a long-term loan. Interest rates rise sharply and the bank decides not to renew the overdraft. What risk has the company exposed itself to, and what could the consequences be?

Answer:
Juno Ltd has accepted a high refinancing risk (aggressive policy). If the overdraft is withdrawn, the company may run out of cash and be unable to pay suppliers or staff, potentially leading to failure. This risk would have been reduced with more long-term finance, albeit at higher cost.

Factors Influencing Funding Policy

The chosen policy may depend on:

• Management’s attitude to risk. Cautious managers prefer conservative policies.
• Predictability and stability of sales and working capital needs.
• The relative cost of short-term and long-term finance.
• The firm’s ability to access various funding sources.
• Previous funding decisions and the company’s size or industry.

Exam Warning

Exam Warning Do not assume that short-term finance is always preferable because it is cheaper. Marks are often lost by failing to discuss the increased risk of refinancing problems and cash shortages.

Revision Tip

If a question requires you to comment on a company’s working capital funding strategy, always discuss both the cost and the risk implications, and recommend a balanced approach in the absence of strong reasons to be aggressive or conservative.

Summary

Selecting how to fund working capital involves balancing the lower cost of short-term finance against its higher risk. A matching (hedging) policy aligns asset types to suitable finance maturities. Aggressive funding increases risk for potential cost savings, while conservative funding minimizes risk but at higher cost. The right mix is influenced by firm-specific factors and management’s risk appetite.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the difference between permanent and fluctuating current assets
• Describe and compare matching, aggressive, and conservative funding policies
• Identify short-term and long-term sources of finance and their cost/risk profiles
• Discuss the main cost versus risk trade-off in working capital funding
• Assess the impact of policy choice on liquidity, profitability, and business risk

Key Terms and Concepts

• permanent current assets
• fluctuating current assets
• matching principle
• refinancing risk