HEDGING PRINCIPLE: A GUIDE TO WORKING CAPITAL FINANCING DECISIONS - Working Capital Management

Financing the firm’s working capital requirements has been shown investment in current assets. Fortunately, there exists a principle which can be used as a guide to firm’s working capital financing decisions. This is the hedging principle or matching principle.

Hedging Principle in Working Capital Management

The hedging principal involves matching the cash flow generating characteristics of assets with the maturity of source of financing used to finance its acquisition.

For example, a seasonal expansion in inventories according to the hedging principle should be financed with a short-term loan or current liability, the rationale underlying the rule is straight forward. Funds are needed for a limited period of time and when that time has passed, the cash needed to repay the loan will be generated by the sale of the extra inventory terms. Obtaining the needed funds from a long-term source would mean that the firm would still have the funds after the inventories have been sold. In this case, the firm would have “excess” liquidity, which they either hold in cash or invest in low-yielding marketable securities until the seasonal increase in inventories occurs again and the funds are needed.

Figure : Financing Strategy

Financing Strategy

Hedging principle provide an important guide regarding the appropriate uses of short-term credit for working capital financing.


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