Maturity Matching or Hedging Approach to Working Capital Financing

Maturity matching or hedging approach is a strategy of working capital financing wherein short term requirements are met with short-term debts and long-term requirements with long-term debts. The underlying principal is that each asset should be compensated with a debt instrument having almost the same maturity.

Maturity Matching or Hedging Approach Equation

This matching approach of working capital financing can be explained in terms of a simple equation as follows

Long Term Funds will Finance = Fixed Assets + Permanent Working Capital

Short Term Funds will Finance = Temporary Working Capital

In the equations, long term funds are matched to long term assets and vice versa.

Hedging or Maturity Matching Approach Diagram

These concepts are best understood with the help of a diagram.In the diagram, we can see three levels, each of fixed assets, permanent working capital and temporary working capital. The red vertical line with white spaces represents the type of financing. The bigger line which stretches till permanent working capital is long-term financing and a smaller line is the temporary working capital. The line from where the temporary working capital starts and the line of a hedging strategy is the same. Any strategy below this line will be an aggressive strategy and a strategy above it will be a conservative strategy.Working Capital Management - Maturity Matching or Hedging Approach to Working Capital Financing Graph

RATIONALE BEHIND MATURITY MATCHING OR HEDGING APPROACH

Knowing why to apply maturity matching strategy is very important. It suggests financing permanent assets with long-term financing and temporary with short-term financing. Now let us suppose opposite situations and see. There can two such situations.

A. Permanent Assets Financed with Short Term Financing: In this situation, the borrower has to renew or refinance the short term loan every time simply because the duration for which money is required is higher, say 3 years, than the available loan is of, say 6 months only. The firm needs to renew the loan 6 times. This firm is exposed to refinancing risk.

If the lender for any reason denies for renewal, what will the firm do? In such a situation for paying off the loan, either the firm will sell the permanent assets which effectively means closing the business or file for bankruptcy.

B. Temporary Assets Financed with Long Term Financing: In this situation, firstly, the borrower has to pay interest on long term loans for that period also when the loan is not getting utilized. Secondly, the interest rate of long-term loans is normally dearer to short term loans due to the concept of term premium. These two additional costs hit the profitability of the firm.

After all the discussion, in situation A, we learned that costs may be low but the risk is too high and situation B concludes high with low risk. Situation A is not acceptable because of such a high risk and situation B hits the profitability which is the primary goal of doing business and basis of survival. Therefore, the hedging or matching maturity approach to finance is ideal for effective working capital management.

Last updated on : July 28th, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Techniques of Managing Accounts Payable / Trade …
  • How EOQ helps in Inventory Management
    How EOQ helps in Inventory Management?
  • Bank Overdraft Facility
    Bank Overdraft Facility
  • Working Capital Cycle
    Working Capital Cycle
  • Intersection of Carrying Cost and Shortage Cost
    Techniques for Finding Optimal Level of Working …
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook


    Related pages


    formula for total asset turnover ratiogordon dividend growth modelroce financial ratiofactoring services definitionbill of lading definebenefit cost ratio bcrwelfare maximizationexamples of mutually exclusive projectswip inventory definitionmargin of safety graphdefinition of overdraft facilityearning per share interpretationcash outlay definitiondupont model roefixed debenturedefine redeemablewhat is short term solvencyadvantages of preparing a cash budgetcan private company issue debentureshypothecate the propertyexplanation of accounting equationoperating income ebitcapital budgeting meaningnpv meaningzero budgeting definitioncharacteristics of zero coupon bondsbank overdrafts definitionnegotiable letter of creditimportance of capital structure in financial managementrbi ecb guidelineswhat is bookkeeping definitionfixed costs and variable costs examples listcalculating hurdle ratem&a typeswhat is the difference between a shareholder and a stockholderwhat are bonds and debenturesrumus average collection periodhurdle rate of returnwhat are cost drivers in accountingexternal commercial borrowings indiadirect vs indirect relationshipworking capital sales ratiopreference shareholderstwo stage ddmformula of inventory turnover ratiofictitious assets exampleshypothecate meaninginterest adalahoperating leverage pdfdefinition of double entry bookkeepingcalculate pay back periodexpensed definitiondirect pay standby letter of creditconvertible debentures indiadiscounting of letter of creditdisadvantages of break even analysiscalculate quick ratio formuladefine callable bondbond covenants exampleswhat does irr mean in financefactoring services definitionrequired rate of return calculator for stocksdefine restrictive covenantsdebt servicing coverage ratiotypical loan covenantsadvantages and disadvantages of borrowing money from a bankinternal sources of finance advantages and disadvantagescalculation of payback perioddisadvantages of retained profitsdefinition of asset turnovernpv valuation methoddefine installment paymentformula for beptypes of debenturesdefinition of profit maximisationaccounts receivable ratio formulawacc calculationdebits and credits for dummiesoperating lease lessorpreference shares fixed dividend