Learning Outcomes
After reading this article, you will be able to explain and compare the three main working capital financing policies: matching, aggressive, and conservative. You will understand the concepts of permanent and fluctuating current assets, evaluate the cost and risk implications of different funding choices, and apply these principles in ACCA Financial Management (FM) exam scenarios.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand how businesses fund current assets. In particular, you should focus your revision on these key syllabus areas:
- The distinction between permanent and fluctuating current assets
- The principles and implications of matching (hedging), aggressive, and conservative working capital financing strategies
- The relative cost and risk of short-term and long-term finance options for working capital
- The impact of working capital funding policy on liquidity, profitability, and business risk
- Management attitudes to risk and their influence on working capital funding decisions
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.
- What is meant by permanent and fluctuating current assets? Give an example of each.
- Which working capital financing policy is generally considered the most risky?
a) Matching policy
b) Aggressive policy
c) Conservative policy
d) Defensive policy - State one advantage and one disadvantage of using short-term finance to fund working capital.
- Explain the main idea of the matching (hedging) approach to funding current assets.
Introduction
Managing working capital is about ensuring that a business has enough resources to operate day-to-day without holding surplus liquid assets that could be invested elsewhere more profitably. An important decision for financial managers is how to finance current assets—namely inventory, receivables, and the cash needed for operations. The chosen strategy affects liquidity, profitability, and the business's risk profile. Three main policies are used: matching, aggressive, and conservative.
Key Term: working capital financing policy
The set of principles guiding how a company funds its current assets, balancing short-term and long-term sources to achieve its goals.Key Term: permanent current assets
The minimum level of current assets required for a company to function continuously, regardless of seasonal or cyclical fluctuations.Key Term: fluctuating current assets
The portion of current assets that rises and falls in line with changes in activity, such as seasonal peaks or temporary increases in sales.Key Term: matching (hedging) policy
A working capital approach where long-term finance funds permanent current assets and short-term finance is used for fluctuating current assets.Key Term: aggressive policy
A working capital strategy that relies heavily on short-term finance, even to fund permanent current assets, increasing risk but often reducing cost.Key Term: conservative policy
A cautious working capital strategy where most or all current assets, including fluctuating elements, are funded with long-term finance, minimizing risk but often at a higher cost.
Permanent versus Fluctuating Current Assets
Current assets can be split into two classes:
- Permanent current assets: The minimum level the business must always hold. This is stable over time.
- Fluctuating current assets: The extra current assets needed during seasonal or cyclical peaks, such as more inventory before a holiday rush.
For example:
- A retailer always needs cash floats and a base inventory (permanent), but must stock extra goods before Christmas (fluctuating).
The method used to fund these assets has implications for both risk and return.
Working Capital Financing Policies
Financial managers choose between three main approaches to funding current assets:
Matching (Hedging) Policy
This approach attempts to match the duration of funding to the duration of asset use.
- Permanent current assets and non-current assets are financed by long-term sources (equity, term loans, long-term debt).
- Fluctuating current assets are financed by short-term sources (overdrafts, short-term loans).
The aim is to avoid both excessive risk and unnecessary cost.
Aggressive Policy
The company funds a significant portion of not just fluctuating but also permanent current assets with short-term finance.
- Short-term borrowing is used to maximise flexibility and reduce funding costs.
- Permanent current assets may be funded by short-term facilities.
This approach is riskier, since short-term finance may need to be refinanced more frequently and may be harder to get in times of tight credit.
Conservative Policy
Here, the manager chooses to fund permanent and much of the fluctuating current assets using long-term sources.
- Even part or all of the seasonal increases are financed with long-term borrowings or equity.
- Often results in idle cash or investments during low-activity periods.
This reduces risk but increases overall funding costs.
Worked Example 1.1
Suppose a company has permanent current assets averaging $500,000 and experiences seasonal peaks that raise current assets to $650,000 for several months each year.
- Under a matching policy, $500,000 would be financed with long-term funds, and the $150,000 peak would use short-term loans.
- Under an aggressive policy, $300,000 might be kept long-term, with $350,000 borrowed short-term.
- Under a conservative policy, the whole $650,000 would be financed long-term.
Answer:
The matching policy aligns the type of finance to asset duration, keeping risks moderate. The aggressive policy increases risk (due to refinancing) but is cheaper. The conservative policy is low risk but increases funding costs by tying up more cash in long-term finance.
Relative Cost and Risk of Short-Term and Long-Term Finance
Short-term finance is usually cheaper—it attracts a lower interest rate as lenders face less uncertainty and are exposed to the borrower for a shorter period. However, heavy reliance on short-term finance raises risk:
- Interest rates on short-term borrowing can fluctuate.
- Facilities may not be renewed at maturity (renewal risk).
- A shortage of credit could force asset sales or disrupt operations.
Long-term finance costs more but provides stability. The risk of having to repay unexpectedly is far less.
Worked Example 1.2
A firm finances all current assets with short-term loans at a variable interest rate. Interest rates unexpectedly double when the loans are rolled over. What is the impact?
Answer:
The firm's interest cost surges, eroding profits and potentially leading to a liquidity crisis. If credit markets are tight, it may be unable to obtain new funding, risking insolvency.
Exam Warning
Choosing an aggressive (short-term) funding policy to maximise profits may backfire if the business cannot refinance expiring short-term facilities, especially during credit squeezes or recessions.
Choosing a Policy: Management Attitude and Other Considerations
- Aggressive policies seek higher returns at higher risk—suitable for businesses with predictable cash flows and strong access to credit.
- Conservative policies lower risk and maximise liquidity, at the cost of higher funding expenses.
- The matching policy is a balanced, moderate approach suitable for most steady businesses.
Other factors influencing policy choice include:
- Management's risk aversion
- Previous funding decisions and existing credit arrangements
- The business's size and access to finance
- Market conditions (interest rate trends, availability of credit)
- Industry standards
Revision Tip
In ACCA exam questions, always comment on the cost-risk trade-off for any working capital funding policy and recommend the approach most appropriate for the business's circumstances.
Summary
- Permanent current assets are best funded with long-term finance; fluctuating assets with short-term finance.
- The matching policy balances cost and risk.
- Aggressive policies reduce costs but heighten refinancing and liquidity risk.
- Conservative policies lower risk but at a higher average financing cost and with idle resources much of the time.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and identify permanent and fluctuating current assets
- Explain the three main working capital financing policies: matching, aggressive, conservative
- Compare the cost and risk implications of short-term versus long-term funding
- Recommend suitable policies based on business risk appetite and context
- Recognise and assess management attitudes to funding risk
Key Terms and Concepts
- working capital financing policy
- permanent current assets
- fluctuating current assets
- matching (hedging) policy
- aggressive policy
- conservative policy