why a firm might deviate from the matching principle by financing short-term assets with long-term debt. How would such a policy have affected a firm during the financial crisis?
A firm might deviate from the matching principle by financing short-term assets with long-term debt for several reasons. One possible reason is that the firm might face difficulties in obtaining short-term financing due to high interest rates or tight credit conditions. As a result, they may choose to use long-term debt to fund their short-term assets in order to ensure sufficient liquidity.
However, this deviation from the matching principle can create mismatched cash flows and financial risks. Here's how:
1. Maturity mismatch: Short-term assets, such as accounts receivable or inventory, typically generate cash flows within a year. On the other hand, long-term debt has a maturity exceeding one year. Financing short-term assets with long-term debt creates a maturity mismatch, where the firm has to repay the debt before the related assets generate sufficient cash flows. This can lead to liquidity problems if the firm experiences delays in cash collection or difficulties in rolling over the debt.
2. Interest rate risk: Long-term debt usually carries a fixed interest rate, while short-term assets' returns and borrowing rates are subject to market fluctuations. If interest rates rise, the firm may find it challenging to generate enough cash flow from the short-term assets to cover the higher interest expense on the long-term debt. This can result in reduced profitability and financial distress.
During the financial crisis, a firm that financed short-term assets with long-term debt would have faced additional challenges:
1. Market disruption: The financial crisis led to severe disruptions in credit markets and a tightening of lending conditions. Access to long-term debt financing became more challenging, and even if available, interest rates on long-term borrowing increased. This would have further exacerbated the mismatch between short-term assets and long-term debt, intensifying liquidity concerns.
2. Cash flow constraints: The financial crisis created a downturn in the economy, affecting sales and cash flows for many firms. If a firm faced reduced liquidity due to the maturity mismatch, it might have been unable to cover its short-term obligations, such as paying suppliers or meeting payroll. This could lead to financial distress, potential bankruptcy, or the need to sell assets at unfavorable prices.
In summary, deviating from the matching principle by financing short-term assets with long-term debt can create a maturity mismatch and expose the firm to interest rate risk. During the financial crisis, such a policy would have worsened liquidity problems and increased financial risks, making it more difficult for the firm to respond to economic challenges and survive the crisis.