Current Assets require financing by use of either current funds or long term funds. There are three major approaches to financing current assets. These are:
a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this approach, the firm adopts a financial plan which involves the matching of the expected life of assets with the expected life of the source of funds raised to finance assets.
The firm, therefore, uses long term funds to finance permanent assets and short-term funds to finance temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This approach can be shown by the following diagram.
b) Conservative Approach
An exact matching of asset life with the life of the funds used to finance the asset may not be possible. A firm that follows the conservative approach depends more on long-term funds for financing needs. The firm, therefore, finances its permanent assets and a part of its temporary assets with long-term funds. This approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:
It should be noted that short-term funds are cheaper than long-term funds. (Some sources of short-term funds such as accruals are cost-free). However, short-term funds must be repaid within the year and therefore they are highly risky. With this in mind, we can consider the risk-return trade off of the three approaches.
The conservative approach is a low return-low risk approach. This is because the approach uses more of long-term funds which are now more expensive than short-term funds. These funds however, are not to be repaid within the year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach. However it is also a high return approach the reason being that it relies more on short-term funds that are less costly but riskier.
The matching approach is in between because it matches the life of the asset and the life of the funds financing the assets.