RISK-RETURN TRADE-OFF AND FINANCING MIX

The financing pattern of current assets point out a conflict between the short term and long term sources of finance.  This conflict between the two arises because of fact that these sources have (i) different cost of financing, and (ii) different risk associated with them.  A financial manager should therefore, strive for a trade-off between the risk and return associated with the financing mix.

The hedging approach results in a low costs-high risk situation while the conservative approach results in a high cost-low risk situation.  The trade-off between risk and return give a financing mix that lies between these two extremes.  For this purpose, the risk and return associated with different financing mix can be analyzed and accordingly a decision can be taken up.  One way of achieving a trade-off is to find out, in the first instance, the average working capital required (on the basis of minimum and maximum during a period).  Then this average working capital may be financed by long term sources and other requirements if any, arising from time to time may be met from short term sources.  For example, a firm may require a minimum and maximum working capital of Rs. 10,000 and Rs. 18,000 respectively during a particular year.  The firm has long term sources of Rs. 14,000 (i.e., average of Rs. 10,000 and Rs. 18,000) and additional requirements over and above Rs. 14,000 may be met out of short term sources as and when the need arises.

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