Bankruptcy' as product of Maturities & Mismatches

When we think about, how the assets of a business are financed. It is from the liabilities incurred by the business. Which are made-up of Debt and Equity. The cost of the debt and equity is the WACC. The WACC is a higher number for companies which are over capitalized or with higher gearing.

When obtaining a credit facility. The business needs to give consideration to the asset it finances. If the asset has a long maturity. It needs to be financed with a longer-term debt. The reason to this is. The asset will generate the income after a certain period and will not be able to repay the liability. If the latter matured prior to the former.

In the same way, if an asset generates income in the shorter term. The business can finance this with a shorter-term liability, or with a medium-term liability. Financing with a longer-term liability will only increase the finance cost of the business. This will reduce net-profits and have an impact on Free-Cash-Flows.

For a business, securing a long-term liability is more beneficial in a rising interest market. But the rate of interest needs to be fixed or have a cap. If the rate of interest is pegged to a market rate i.e., LIBOR or SOFR. Then the rate is floating and will adjust accordingly. To the contrary, a short-term liability is better, when interest rates are dropping. The liability can be revolved at a lower rate once matured.

The business can use debt instruments, to manage the liabilities prudently. Such instrument being Corporate Debentures or Bonds (Depending on whether issued against security or unsecured). These instruments allow the issuer to borrower over a long term at fixed or floating rates. Making it one of the ideal means to manager maturities and reduce mismatches between assets and liabilities.

Building a capital reserve, from annual profits. Is also a supporting factor, as equity is much cheaper than debt. The reserve can be capitalized at crucial times to serve this purpose. Another advantage of equity is that it can be bought back, and cancelled, if an overcapitalization is increasing the WACC.

The fact is that when, liabilities fall due the assets need to meet them. This is to avoid a mismatch which is a result of maturities not placed due to lack of financial literacy. This if not kept in check can lead to an illiquid situation which in turn can lead to an unsystematic risk of creating a Bankruptcy.

I hope this article, served some insights to the businesses especially the SME's . Any further clarification, feel free to leave a comment.

By : Dilshan Nagahawatta