This question is about the maturity matching approach to financing. The maturity matching approach to financing current assets (also called the hedging or the self-liquidating approach) matches assets to be financed with financing having the same maturity. Even though the assets being financed with short-term debt are current assets, if they are permanent, they will not be liquidated the way other current assets would be. Examples of permanent current assets are accounts receivable and inventory in a non-seasonal business or in a growing business. Inventory is sold, but it is immediately replaced with new inventory, so the level of investment in inventory remains the same. Accounts receivable get collected, but they are immediately replaced by accounts receivable for other sales, so the level of accounts receivable also remains the same. And in a firm that is growing, accounts receivable and inventory don't just remain the same — they increase. And they continue increasing until the firm's growth stops. In either a non-seasonal business or in a growing business, the level of the accounts receivable and inventory required to support sales will be permanent and they should be financed with long-term debt. (If the business is seasonal, at least a portion of their accounts receivable and inventory will be liquidated after the selling season, so only a portion of their accounts receivable and inventory will be permanent.) If a company finances permanent, long-term assets with short-term debt, it may be able to lower its interest costs, if short-term interest rates are lower than long-term fixed interest rates (which is usually the case). However, it runs two risks: (1) of not being able to renew the short-term financing when it matures and being required to pay it off when funds are not available because the current assets have not been liquidated, potentially putting the firm into bankruptcy; and (2) of being forced to renew the short-term debt at a higher interest rate in a period of rising interest rates. If short-term interest rates increase enough, the firm may find itself paying a higher rate of interest than it would have paid if it had originally financed the permanent assets using long-term, fixed rate financing. Because of the risks involved, using short-term financing for long-term, permanent assets is considered an aggressive, risky approach to financing. The greater the proportion of permanent assets financed with short-term debt, the more aggressive the financing is and the greater the level of risk the firm faces.
This question is about the maturity matching approach to financing. The maturity matching approach to financing current assets (also called the hedging or the self-liquidating approach) matches assets to be financed with financing having the same maturity. It is appropriate to finance fluctuating current assets with short-term debt. A financing policy like this enables a firm to borrow only what it needs for only as long as it needs it. This minimizes its interest costs because it does not have borrowed funds on hand that it is not using.
This question is about the maturity matching approach to financing. The maturity matching approach to financing current assets (also called the hedging or the self-liquidating approach) matches assets to be financed with financing having the same maturity. It is not appropriate to finance fluctuating current assets with long-term debt because the firm could find at times that not all of its long-term borrowings are required to finance the level of current assets. The result will be that the firm will be paying interest on loan balances that it does not need to pay. If the firm chooses to pay down the loan principal during a period when it does not need all of the borrowings, the next time the current assets increase and the firm needs the financing for them, they will not be there. Thus it is much better to finance fluctuating current assets with short-term debt, because a firm using long-term debt runs the risk of (1) having too much in borrowings and thus interest expense that is too high; and/or (2) not having enough borrowings available when needed if the firm has paid down the long-term loan during a period when it had plenty of cash.
It is appropriate to finance permanent current assets with long-term debt. This question is about the maturity matching approach to financing. The maturity matching approach to financing current assets (also called the hedging or the self-liquidating approach) matches assets to be financed with financing having the same maturity. Examples of permanent current assets are accounts receivable and inventory in a non-seasonal business or in a growing business. Inventory is sold, but it is immediately replaced with new inventory, so the level of investment in inventory remains the same. Accounts receivable get collected, but they are immediately replaced by accounts receivable for other sales, so the level of accounts receivable also remains the same. And in a firm that is growing, accounts receivable and inventory don't just remain the same — they increase. And they continue increasing until the firm's growth stops. In either a non-seasonal business or in a growing business, the level of the accounts receivable and inventory required to support sales will be permanent. (If the business is seasonal, at least a portion of their accounts receivable and inventory will be liquidated after the selling season, so only a portion of their accounts receivable and inventory will be permanent.)
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