Author : Konstantina Karatzoudi
Short-term debt or current liabilities are a company’s obligations that require payment within one year or within the operating cycle, if this is shorter. This short-term debt can be used as funding to match the terms of a specific project or in cases of unmatched funding, the maturity and duration of the debt do not match the funding requirements of a specific project. The most common situation is that companies prefer that funding be matched to ensure funding availability throughout their projects. Matching principle is a standard theory of finance, which states that firms should finance their short-term assets with short-term liabilities and long-term needs with long-term capital.
The method of using short-term debt to finance long-term assets can be an attractive option, especially during economic crises, as short-term debt is more readily available and is offered at variable interest rates determined by the market. It is mostly attractive to small companies that more possibly face difficulties in raising long-term capital and thus, they turn to more viable funding alternatives. Using the option to finance its long-term projects, a company does not have any other choice than to fully utilize the resources available, as it must pay back the debt and interest to its creditors.
However, numerous companies had to deal with a trouble situation after having used the easy availability of short-term lines of credit, especially when they purchased assets, such as equipment with money borrowed from short-term loans, without matching the terms of the loan with the life of the asset. Companies should evaluate the risks involved and when those risks become excessive, before they make the decision to finance long-term assets with short-term debt. In case businesses violate the matching principle, they run three serious risks. Firstly, the interest rate risk, which can easily be higher at the time of loan renewal. Usually, working capital agreements involve floating interest rate instead of a fixed one. The exposure of companies to high and fluctuating interest rates can seriously affect their survival, especially the survival of small companies. Secondly, as companies heavily rely on working capital loans, they should consider the possibility of an arrangement termination, if the lender decides about it. In this case, companies should have alternative resources to turn to ensure available funding for their operations. Thirdly, it is possible that lenders insist on revised terms in the agreements, for example, requiring more security, personal guarantees or higher charges. If these changes coincide with an unfavorable economic situation, as the financial crisis during the last years, this can result in difficult times for the companies, hindering them from meeting their obligations.
Therefore, achieving the goals of corporate finance requires appropriate financing of any business investment. It is critical that interest expenses never exceed the net operating income margin. This situation must be avoided, as it is a negative leverage. Management should try to match as closely as possible, the short-term or long-term debt financing with the assets that are financed in terms of timing and cash flows.
Future's Management 