It is important for every business owner to understand the consequence of deploying short term funds (mostly debt) to long term commitments.
In the current scenario of ongoing COVID-19, which has brought about sudden change in the way one should do business, every entrepreneur is learning and adapting to change its course of conducting its business.
Hence in the present context of ongoing economic slow down many business may been affected in varied degrees from the aspect of Cash Flows. It is now equally more important to learn and understand the financial consequences of using short term debt for long term investment.
But why do Businesses end up using Short-Term capital towards Long-Term commitments ?
In my earlier blog, i had discussed on the pros and cons of long-term and short-term borrowing where its was mentioned how short-term funds are comparatively easily available in least possible time than the latter. Other major reason being is lack of knowledge in effectively managing working capital.
Generally a short-term debt funds have a debt repayment tenure ranging from from 5 – 15 months depending on cash flows and other terms.
Let’s understand this using an example:
Imagine you have rented a house and have set aside a capital in the form of fixed deposits (FD) to pay for the recurring rentals every month. If your FD interest accrued is be credited once annually, this clearly will lead you to asset-liability mismatch leading you to default on rentals every month.
The above example is over-simplification of a complex concept but this sets the perspective to understand the issue in hand.
But, what classifies as long term commitments:
Any capital expenditure (capex) which has a low return on capital or a longer period of break-even would classify as long term investments and few examples would be
a. Purchase of new machinery
b. Purchase of land / building for business
c. Purchase of vehicle to transport goods
d. Taking over existing business
e. Expenditure on Brand Building
f. Purchase of software to automate business process
g. Expenditure of renovation of factory / office sites
It is usually prudent to undertake these long term capital expenditure through free cash flow generated out of the normal course of business and hence adding assets to the balance sheet or by taking long term loan with repayment tenure above 7 years.
A business owner should equip his knowledge on sound working capital management. Good management of working capital is difficult for a company which persistently routes funds meant for working capital into fixed assets; a working capital crunch is usually the first manifestation of the deeper problem of a funding mismatch. By the time the problem surfaces in this manner, however, the damage to the company’s credit profile has already been done. This can also be extrapolated for personal finances.
To learn more about the same, you may get in touch with me via email firstname.lastname@example.org
Bokdia GroFin Business Services LLP