Companies that take a maturity-matching approach match assets and liabilities that have the same maturity terms. This means that assets balance with liabilities on either a short-term or long-term basis. Using this approach, companies do not fund a short-term asset with a long-term liability, for example. This approach hedges risk, enables tighter financial control and impacts on the liquidity profile of the business.
The maturity-matching approach requires that short-term assets be financed by short-term liabilities and long-term assets by long-term liabilities or equity. When a short-term debt matures, the short-term asset it finances also matures and can be used to repay the debt on time. By the same token, a long-term asset should be financed by funds of long-term sources to ensure no interruptions in the asset’s use of funds on a long-term basis. Mismatched maturities can cause liquidity issues on both the liability and asset sides.
When companies finance long-term assets with short-term liabilities, they are taking on a potential liquidity risk. As the short-term liabilities mature, the long-term assets that use the short-term funds do not mature until much later. If companies fail to roll over, or refinance, their short-term liabilities, they face either a default on the debt or a premature asset sale. It’s also not wise that companies finance short-term assets with long-term liabilities. As a short-term asset matures quickly, companies have to find other uses for the long-term funds now available again. Matching maturities of assets and liabilities avoids both potential problems.
The cost of financing with short-term liabilities usually is cheaper than the cost of financing with long-term liabilities, and that’s why sometimes companies are drawn to using short-term liabilities for many of their financing needs. However, initial money savings can be offset or exceeded by damage to company credit ratings or loss from untimely asset sales. On the other hand, financing with long-term liabilities for all assets increases financing cost instantly. The maturity-matching approach uses a combination of short-term and long-term liabilities and may achieve a lower financing cost on average.
Companies that use more short-term liabilities in their asset financing face potential interest-rate risk if there is an increase in short-term interest rates. As their initial short-term liabilities mature, companies need to refinance them to keep any long-term assets fully funded but can do it only at higher short-term interest rates. An advantage of matching the maturities of short-term assets with short-term liabilities is that extra costs paid on new short-term liabilities will be compensated by extra returns earned on new short-term asset investments because higher short-term interest rates apply to both borrowing and investing.