Question

As the finance manager for a growing mining services company, you approach Bank West Limited to discuss their range of business loan facilities. Identify the fundamental principle of finance that relates to the use of both short-term and medium to longer-term finance by a business. Explain the principle and discuss why it is important.As the finance manager for a growing mining services company, you approach Bank West Limited to discuss their range of business loan facilities. Identify the fundamental principle of finance that relates to the use of both short-term and medium to longer-term finance by a business. Explain the principle and discuss why it is important.

Answer 1

The fundamental principle of finance that relates to the use of both short-term and medium to longer-term finance by a business:

The short term finance should be used to finance the short term goals and objectives. This is primarily to ensure that there is no mismatch between assets and liabilities. This is to ensure that when your liability matures, the asset also matures to provide the cash flows good enough to retire the matured liabilities.

Explain the principle and discuss why it is important.

The short term finances should be used for working capital financing, short term bridge or receivables factoring or raw material purchases funding.

The medium to long term finance should be used for the purpose of financing capital assets, plants, machinery, building, equipment, land etc. Such assets usually have a gestation period before they start yielding free cash flows. Thus they will produce free cash flows in the long run and hence can be used to pay off the liabilities maturing in the long run.

Thus asset liability maturity principle must be kept in mind when deciding short term and medium to long term finances and their purposes. Using short term loans to fund capital assets will result in a situation where liabilities fall due within the year, but the asset may not be even ready to perform. This will lead to distress situation for the firm.

Explain the principle and discuss why it is important