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Debt Financing Essay

4203 words - 17 pages

111008 – Research in Business and Economics Journal

Determinants of short-term debt financing
Richard H. Fosberg William Paterson University ABSTRACT In this study, it is shown that both theories put forward to explain the amount of shortterm debt financing that a firm employs have validity. The matching principle correctly predicts that the amount of short-term debt financing that a firm uses is directly related to the quantity of the firm’s current assets. Additionally, other factors that have been shown to affect the levels of long-term debt financing that a firm employs are also shown to affect the amount of short-term debt financing that a firm uses. Specifically, the amount of firm ...view middle of the document...

These factors include firm size, profitability and market-to-book ratio. The purpose of this study is to determine whether the matching principle fully explains the amount of short-term debt financing that a firm employs or if factors that affect the amount of long-term debt financing that a firm uses also affect the amount of short-term debt financing that a firm employs. SHORT-TERM DEBT THEORY According to the matching principle of finance, short-term assets should be financed with short-term liabilities and long-term assets should be financed with long-term liabilities (Guin (2011)). Short-term assets and liabilities are generally defined to be those items that will be used, liquidated, mature or paid off within one year (Guin (2011)). A firm’s current assets (including cash, inventories, accounts receivable, etc.) are generally considered short-term assets while plant and equipment are generally considered long-term assets. Nevertheless, current assets can be long-term if they are not completely used or liquidated during the year. For example, suppose a firm’s raw materials inventory is used and replenished periodically so that the level of inventory varies between $600 and $900 during the year. The minimum level of raw materials inventory ($600) is effectively a long-term inventory investment as the inventory level never drops below this amount. The difference between the maximum and minimum values ($300) is a temporary inventory investment that is liquidated at some point during the year. On the other side of the balance sheet, current liabilities (accounts payable, short-term debt, etc.) are usually considered short-term liabilities while long-term debt (debt with a maturity of more than one year) and equity capital are considered long-term liabilities. However, current liabilities can be a source of long-term financing if they are not completely paid off during the year. For example, assume a firm periodically receives and pays off short-term loans in such a way that the firm’s short-term loan balance varies between $300 and $500 during the year. The $300 minimum loan balance is effectively a long-term source of financing while the difference between the maximum and minimum loan balances ($200) is short-term financing that is paid off during the year. Notwithstanding the above, if it is assumed that a firm’s current assets (CA) and current liabilities (CL) are short-term assets and short-term financing, respectively, the matching principle implies that a firm’s current assets should equal its current liabilities. Next, define spontaneous current liabilities to be liabilities whose values change during the year without any explicit action by the firm’s managers. For example, when a firm grows it generally purchases more goods and services from its suppliers resulting in a spontaneous increase in accounts payable. Assuming current liabilities, other than short-term debt, are relatively spontaneous

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