Question

In: Finance

What are the advantages of matching the maturities of assets and liabilities? What are the disadvantages?...

What are the advantages of matching the maturities of assets and liabilities? What are the disadvantages? Why?

Solutions

Expert Solution

Advantages of matching the maturities of assets and liabilities

Companies that take a maturity-matching approach match assets and liabilities that have the same maturity terms. This means that assets balance with liabilities on either a short-term or long-term basis. Using this approach, companies do not fund a short-term asset with a long-term liability, for example. This approach hedges risk, enables tighter financial control and impacts on the liquidity profile of the business.

Maturity Matching

The maturity-matching approach requires that short-term assets be financed by short-term liabilities and long-term assets by long-term liabilities or equity. When a short-term debt matures, the short-term asset it finances also matures and can be used to repay the debt on time. By the same token, a long-term asset should be financed by funds of long-term sources to ensure no interruptions in the asset’s use of funds on a long-term basis. Mismatched maturities can cause liquidity issues on both the liability and asset sides.

Liquidity Risk

When companies finance long-term assets with short-term liabilities, they are taking on a potential liquidity risk. As the short-term liabilities mature, the long-term assets that use the short-term funds do not mature until much later. If companies fail to roll over, or refinance, their short-term liabilities, they face either a default on the debt or a premature asset sale. It’s also not wise that companies finance short-term assets with long-term liabilities. As a short-term asset matures quickly, companies have to find other uses for the long-term funds now available again. Matching maturities of assets and liabilities avoids both potential problems.

Financing Cost

The cost of financing with short-term liabilities usually is cheaper than the cost of financing with long-term liabilities, and that’s why sometimes companies are drawn to using short-term liabilities for many of their financing needs. However, initial money savings can be offset or exceeded by damage to company credit ratings or loss from untimely asset sales. On the other hand, financing with long-term liabilities for all assets increases financing cost instantly. The maturity-matching approach uses a combination of short-term and long-term liabilities and may achieve a lower financing cost on average.

Interest-Rate Risk

Companies that use more short-term liabilities in their asset financing face potential interest-rate risk if there is an increase in short-term interest rates. As their initial short-term liabilities mature, companies need to refinance them to keep any long-term assets fully funded but can do it only at higher short-term interest rates. An advantage of matching the maturities of short-term assets with short-term liabilities is that extra costs paid on new short-term liabilities will be compensated by extra returns earned on new short-term asset investments because higher short-term interest rates apply to both borrowing and investing.

Disadvantage

However there is some difficulty in implementing this approach. It is not always possible to finance the short term assets with short term financing or long term assets with long term financing. The bank may not be willing to lend to the company or the debtors may not pay the receivables on time.


Related Solutions

What are the advantages of matching the maturities of assets and liabilities? What are the disadvantages?...
What are the advantages of matching the maturities of assets and liabilities? What are the disadvantages? Why? Respond in at least 200 words.
What valuation methods reflect historical cost? Discuss the advantages and disadvantages of valuing assets and liabilities...
What valuation methods reflect historical cost? Discuss the advantages and disadvantages of valuing assets and liabilities using historical valuations.
What are the advantages and disadvantages of a purchase of assets from the perspectives of the...
What are the advantages and disadvantages of a purchase of assets from the perspectives of the buyer and the seller?
What are the potential advantages and disadvantages of recording assets in the books of account following...
What are the potential advantages and disadvantages of recording assets in the books of account following the historical cost principle?
What are the advantages and disadvantages of brick-and-mortar stores? What are the advantages and disadvantages of...
What are the advantages and disadvantages of brick-and-mortar stores? What are the advantages and disadvantages of online stores? Which are there more of and how will this trend continue? Please answer in complete sentences with an overall total of 150 words or more.
The "matching principle" refers to? a. Making sure assets equal liabilities plus equity on the balance...
The "matching principle" refers to? a. Making sure assets equal liabilities plus equity on the balance sheet b.Matching costs with associated revenues to determine profits c.Matching sales to the correct advertising campaign d.Matching current liabilities to current assets on the balance sheet Which of the following statements regarding depreciation is false? a.Depreciation is a method of spreading the cost of an item over its useful life b.Depreciation is a non-cash expense c.Depreciating an investment faster will result in better cash...
What are advantages and disadvantages of Preferred Stock? Do they outweigh the advantages and disadvantages of...
What are advantages and disadvantages of Preferred Stock? Do they outweigh the advantages and disadvantages of Common Stock?
What are the advantages and disadvantages of globalization? The advantages and disadvantages of globalization can change...
What are the advantages and disadvantages of globalization? The advantages and disadvantages of globalization can change depending on whether or not they are being evaluated from a social or economic perspective. From an economic standpoint, globalization has provided ample opportunity for a number of American businesses to grow exponentially. Globalization has also had a large impact on how businesses are structured by altering supply chains which has arguably led to greater efficiency as well as lowering the cost of manufacturing...
What are the advantages and disadvantages of IRR?
What are the advantages and disadvantages of IRR?
What are the advantages and disadvantages of the NMOS?
What are the advantages and disadvantages of the NMOS?
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT