Question

Briefly explain maturity matching approach, aggressive approach and conservative approach of current assets financing policies? Explain what are the advantages and disadvantages of using short-term versus long-term debt in financing a firm’s current assets.

Answer 1

Working capital Approaches:

A) Matching or hedging approach: This approach matches assets and liabilities to maturities. Basically, a company uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets.

B) Conservative approach: it is conservative because the company prefers to have more cash on hand. That is why, 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”.

C) Aggressive approach: The Company wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.

Although using short-term credit is generally riskier than using long-term credit, short-term credit does have some significant advantages.

A short-term loan can be obtained much faster than long-term credit. Lenders insist on a more thorough financial examination before extending long-term credit. If a firm’s needs for funds are seasonal or cyclical, it may not want to commit to long-term debt because: (1) flotation costs are generally high for long-term debt but trivial for short-term debt. (2) prepayment penalties with long-term debt can be expensive. Short-term debt provides flexibility. (3) long-term loan agreements contain provisions that constrain a firm’s future actions. Short-term credit agreements are less onerous. (4) the yield curve is normally upward sloping, indicating that interest rates are generally lower on short-term than on long-term debt.

Even though short-term debt is often less expensive than long-term debt, short-term debt subjects the firm to more risk than long-term financing. The reasons for this are: (1) if a firm uses long-term debt, its interest costs will be relatively stable over time; however, if the firm uses short-term debt, its interest expense will fluctuate widely. (2) if a firm borrows heavily on a short-term basis, it may find itself unable to repay this debt, and it may be in such a weak financial position that the lender will not extend the loan, which could force the firm into bankruptcy