Working Capital Funding Strategies

The last topic asked how much to invest in working capital. This one asks how to pay for it. Some of what a business holds in inventory, receivables and cash is needed every day of the year; some is needed only at the seasonal peak. Short-term finance, such as an overdraft, is cheap and flexible but can be withdrawn at short notice; long-term finance is dearer but safe.

The matching of the type of finance to the type of asset is the central idea of working capital funding.

This topic covers permanent and fluctuating current assets and working capital, the cost and risk of short-term and long-term finance, the three funding policies (aggressive, matching and conservative) with a costed comparison, the factors that influence the choice, and the link between the investment policy and the funding policy, including what overtrading teaches about funding long-term assets with an overdraft. The next topic starts the study of investment appraisal.

The funding principle was tested in the compulsory question of May Diet, 2026, Question 1(b), where an overdraft that had risen to ₦5.2m was financing non-current assets, and the memorandum recommended converting part of the overdraft into longer-term finance. Read working capital investment policy and determining needs first.

Permanent and fluctuating working capital

Permanent current assets are the part of current assets that stays fixed over time: buffer inventory, the receivables outstanding during the credit period and the minimum cash balance. Fluctuating current assets change in value or quantity with the business: inventory held for sale, amounts owed by customers and liquid funds for daily operations, moved by seasonal demand, sales cycles, production levels and customers’ payment terms.

In the same way, permanent working capital is the minimum amount a company must always have to support its operations. It is fixed, a long-term requirement and essential for the daily running of the business. Fluctuating working capital is the variable amount needed at certain times of the business cycle, a short-term requirement tied to seasonal changes in demand or production.

Short-term and long-term finance: cost and risk

Short-term finance is less expensive but has a higher risk of being withdrawn, which can create a liquidity crisis. Long-term finance (debt and equity) is more expensive but has a lower risk. Interest rates also move: a loan renewed each year is exposed to a rise in rates, while long-term finance fixes the cost.

The three funding policies

• Aggressive: long-term finance funds non-current assets, and short-term finance funds all working capital, permanent and fluctuating. Risky but profitable, because short-term finance is the cheapest.
• Matching: long-term finance funds non-current assets and permanent working capital, and short-term finance funds fluctuating working capital. The duration of the finance matches the duration of the investment (the matching principle).
• Conservative: long-term finance funds non-current assets, permanent working capital and part of the fluctuating working capital. Little short-term finance is used. Stable but expensive.

A costed comparison

A company has non-current assets of ₦300m and permanent current assets of ₦80m. Its fluctuating current assets reach a peak of ₦60m and average ₦30m over the year. Long-term finance costs 12% and short-term finance 9%; surplus cash earns 6%.

The aggressive policy is cheapest and the conservative is dearest, as the theory predicts. But the aggressive policy has the most short-term borrowing: if short-term rates rose by 3 percentage points, its cost would rise by 110 × 3% = ₦3.3m, compared with ₦0.9m for the matching policy and nothing for the conservative policy.

The matching policy is a compromise: it keeps short-term borrowing to the seasonal element that will be repaid when the peak is over.

Choosing a policy

The final choice should consider the size of the organisation (larger firms have more access to long-term markets), the willingness of creditors to lend, the risks of the industry (stable businesses can borrow short more safely) and past experience of funding decisions. Management’s attitude to risk drives the choice between the policies.

Investment policy and funding policy together

The two sets of decisions are similar and different. They are similar in that each is a choice between an aggressive and a conservative stance, with profit and risk moving together. They differ in what they decide: the investment policy decides how much to hold in current assets, and the funding policy decides how that investment is paid for.

A company can have an aggressive investment policy (low working capital) and a conservative funding policy (long-term finance), or the reverse. The most dangerous combination is a high, growing investment funded by short-term finance, which is what happens in overtrading.

The overtrading example from the scenario illustrates this: non-current assets had risen by ₦4.6m but long-term finance by only ₦2.0m, so the overdraft, which is repayable on demand, funded a long-term asset. The remedy is to convert part of the overdraft into a term loan or equity, to match the funding with the assets.

The ideas in more depth

Why the matching principle is a guide and not a rule

Perfect matching is not possible, because the permanent part of working capital is itself uncertain, and a company wants some margin of safety. It is also affected by the shape of the yield curve and the cost of arranging finance. The principle tells the manager the starting point and the direction in which risk increases.

Why the overdraft is both useful and dangerous

An overdraft is flexible and cheap, and is the natural way to fund the seasonal peak. But it is repayable on demand, so a bank that recalls it when the company is already stretched can bring about the collapse that the funding policy was meant to prevent.

Putting numbers on the three policies

A company has non-current assets of \u20a61,500m, permanent current assets of \u20a6800m, and fluctuating current assets that average \u20a6200m, peaking at \u20a6350m and falling to \u20a650m through the year. Long-term finance costs 24% and short-term finance 22% (assumed for the illustration). Surplus cash earns 10%.

• Conservative:
  all non-current and permanent assets and the peak of the fluctuating assets are financed long term: 1,500 + 800 + 350 = \u20a62,650m at 24% = \u20a6636m.
  Over the year about \u20a6150m is idle on average and earns 10%, \u20a615m, so the net cost is \u20a6621m.
• Matching (moderate):
  long-term finance covers non-current and permanent current assets, 1,500 + 800 = \u20a62,300m at 24% = \u20a6552m, and the fluctuating assets are financed short term, 200 \u00d7 22% = \u20a644m: total \u20a6596m.
• Aggressive:
  long-term finance covers non-current assets and half the permanent current assets, 1,500 + 400 = \u20a61,900m at 24% = \u20a6456m, and the other \u20a6400m of permanent and the \u20a6200m of fluctuating assets are financed short term, 600 \u00d7 22% = \u20a6132m: total \u20a6588m.

The aggressive policy saves only \u20a68m against matching (588 against 596), but it leaves \u20a6600m of short-term borrowing that must be renewed every year at a rate no one knows in advance, with the lender free to refuse. A rise of three points in the short-term rate would add 600 \u00d7 3% = \u20a618m, more than the saving.

The conservative policy costs \u20a625m more than matching but gives the greatest security. The choice therefore depends on how stable the company\u2019s cash flows are, how easily it can borrow and how much risk its directors will accept, not on cost alone.

Practical steps for a Nigerian company

Where interest rates are high and change often, a company that relies on short-term borrowing should arrange committed overdraft or revolving facilities before it needs them, keep a liquidity reserve above its forecast minimum, spread the dates on which its loans fall due so that they are not all renewed in the same month, and match the currency of its borrowing to the currency of the cash it will receive.

These steps are a form of matching, applied to liquidity as well as to maturities.

How to recommend a policy

• Classify the assets first: separate non-current assets, permanent current assets and the fluctuating part, using the lowest level of each as the permanent amount.
• Cost each policy with the rates given, including any interest earned on idle cash.
• Measure the risk, not only the cost: the amount that must be refinanced each year, the effect of a rise in the short-term rate and the company\u2019s interest cover.
• Recommend and justify: matching for most companies, a more conservative policy for a business with volatile cash flows, and an aggressive policy only where funds are easy to raise and the saving is large.

Sources and references

• No accounting standard governs funding policy. Current and non-current liabilities are classified under International Accounting Standard (IAS) 1 Presentation of Financial Statements, so a loan repayable on demand is a current liability.

These points are stated as at 5 November 2026.

Worked examples

1. Long-term.
   12% × ₦380m = ₦45.6m.
2. Short-term.
   9% × ₦30m = ₦2.7m, so total ₦48.3m.

1. Cost.
   ₦36.0m + ₦9.9m = ₦45.9m.

1. Extra cost.
   3% × ₦110m = ₦3.3m.

How to answer in the exam

• Split the assets into non-current, permanent current and fluctuating current before choosing a policy.
• Cost each policy from the amounts and rates, and include the return on surplus cash for the conservative one.
• Relate the cost to the risk, using the sensitivity to a change in short-term rates.
• Apply to the scenario: say where a long-term asset is being funded short and how to correct it.

Common mistakes in the exam

• Treating all working capital as fluctuating.
• Saying that the conservative policy is the cheapest because it is the safest.
• Forgetting the average, not the peak, for short-term borrowing.
• Confusing the investment policy with the funding policy.
• Funding long-term assets with an overdraft without comment on the risk.
• Ignoring the interest rate risk of short-term finance.

Quick revision

• Permanent working capital: always needed. Fluctuating: seasonal.
• Short-term finance: cheap, risky. Long-term: dear, safe.
• Aggressive: all working capital short. Matching: permanent long, fluctuating short. Conservative: long for part of the fluctuating too.
• Investment policy = how much; funding policy = how paid for.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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