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.
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