Question

When organizations decide to finance assets, the key is to match meaning current assets with current financing and long term assets with long term financing.

What would be an example of this occurring in business today and what would be the disadvantage from not matching?

Answer 1

The maturity matching principle is the concept that a firm should finance current assets with short-term liabilities and fixed assets with long-term liabilities. Fixed assets have a useful life of a year or more, while current assets are generally used up in less than a year. The maturity matching principle is an important consideration for business liquidity and profitability.

ADVANTAGES OF MATCHING MATURITY APPROACH

OPTIMUM LEVEL OF FUNDS (LIQUIDITY)

The funds remain on the balance sheet only till they are in use. As soon as they are not needed, they are paid. This is how the interest cost is optimized in this strategy. Interest is paid only for the amount and time for which money is used. There is no unutilized cash lying idle with the business.

SAVINGS ON INTEREST COSTS

When short-term requirements are not funded with long-term finances, the firm saves interest rate difference between long term and short term interest rates. It is already known that long-term interest rates are comparatively higher due to the concept of risk premium.

NO RISK OF REFINANCING AND INTEREST RATE FLUCTUATIONS DURING REFINANCING

Since the fundamental principle of finance is followed here i.e. long term asset to long-term finance and short term assets to short term finance, there are no risk of refinancing and the interest rate fluctuations during refinancing. This means that while renewing a loan if the market scenario changes, the rate of interest may also adversely change. Here, there is no problem of frequent refinancing.

DISADVANTAGES OF MATCHING MATURITY APPROACH

DIFFICULT TO IMPLEMENT

It is one of the best strategies or ideal strategy but it is very difficult to implement. Exactly matching the maturity of assets with their source of finance is practically not possible. There is quite a lot of uncertainty on current asset’s side. One cannot exactly predict at what time, the debtor will pay or what time the sales will occur. Once the credit is extended, the ball goes in the court of the debtor.

RISKS STILL PERSIST

After adopting this strategy and planning everything in accordance with it, if the assets are not realized on time, it will not be possible to extend the loan due dates unreasonably. In that situation, the strategy moves either towards conservative or aggressive approach. Once that happens, the analytics and risks of those strategies will apply. The risks which are avoided with this strategy again come into play.