When considering how working capital is funding it is useful to divide assets into permanent current assets, noncurrent assets and fluctuating current assets. Permanent current assets symbolize the core level of working capital investment needed to support a given level of sales. As sales raise this core level of working capital also increases. Variable current assets represent the changes in working capital that arise in the normal course of business operations for example when some accounts receivable are settled later than expected or when inventory moves more slowly than planned.
The matching principle proposes that long-term finance should be used for long-term assets. In a matching working capital funding policy consequently long-term finance is used for both permanent current assets and non-current assets. Short-term finance is utilized to cover the short-term changes in current assets represented by fluctuating current assets.
Long-term debt has a higher cost in comparison of short-term debt in normal circumstances for instance because lenders require higher compensation for lending for longer periods or because the risk of default increases with longer lending periods. Though long-term debt is more secure from a company point of view than short-term debt since provided interest payments are made when due and the requirements of restrictive covenants are met terms are fixed to maturity. Short-term debt is riskier in comparison long-term debt because for example an overdraft is repayable on demand and short-term debt may be renewed on less favourable terms.
A conservative working capital financial support policy will use a higher proportion of long-term finance than a matching policy thus financing some of the fluctuating current assets from a long-term source. This will be less risky as well as less profitable than a matching policy and will give rise to occasional short-term cash surpluses.
An forceful working capital funding policy will use a lower proportion of long-term finance than a matching policy financing some of the permanent current assets from a short-term source such as an overdraft. This will be more risky as well as more profitable than a matching policy.
Other factors that manipulate a working capital funding policy include management attitudes to risk and previous funding decisions and organisation size. Management attitudes to risk will conclude whether there is a preference for a conservative an aggressive or a matching approach. Previous financial support decisions will determine the current position being considered in policy formulation. The dimension of the organisation will influence its ability to access different sources of finance. A small company for instance may be forced to adopt an aggressive working capital funding policy for the reason that it is unable to raise additional long-term finance whether equity of debt.