Have you ever wondered which of your firm's liabilities funds which assets? My early attempts to divine such a relationship (and I speak of the pre-PC era here) came to nought; all I got to hear from the learned masters was that the Balance Sheet is to be viewed in terms of pools of assets, and pools of liabilities. At best you could have sub-pools (as in Fixed assets and current assets, and short-term liabilities, long-term liabilities, and shareholders' funds), and these sub-pools could be seen funding each other, but it got no more specific than that.
Most of us are introduced to balance sheets as being a snapshot of the state of affairs of the business they pertain to. Some of them are tinted, usually in rose so the figures look nicer. While some are dressed appropriately to suit the occasion, some even often a panoramic view. Dressed or otherwise, we are trained and conditioned to see the Balance Sheet as no more than a point-in-time statement of the financial affairs of the business.
THE SHIFT IN PARADIGM
One notable departure from this Balance Sheet paradigm was when IAS 30 (issued in 1990; now supplanted by IFRS 7) required banks to sort assets and liabilities into maturity buckets and match them.
Now we have a methodology for all entities, even those outside the banking arena. It is a simple-to-conceptualize health-check to determine whether and to what extent the company is using short term liabilities to fund long-term assets or even medium-term assets.
The funding paradigm is that assets should be funded by liabilities of matching duration, to avoid mismatches between the timing of payment of liabilities and the corresponding cash flow stream emanating from assets. For example, using a short-term liability to fund a longer duration asset gives rise to the obvious risk of the liability maturing before the asset converts to cash, requiring the company to depend on refinancing as the primary means of keeping that asset continuously funded. Hence prudent financial management would entail identifying all such mismatches and remedying them in good time, when you have the luxury of choosing between funding alternatives.
The methodology is as follows:
Â Â Â Â Â Â List out all your liabilities vertically, starting with the longest-term liabilities at the top and moving down to short-term liabilities, with amounts listed alongside.
Â Â Â Â List all your assets horizontally starting with the longest-lived assets at the left and moving across right to short-term assets, with amounts listed underneath. The basic sorting criterion is “distance from cash”.
Â·Â Â Â Â Â Â Â Â In the grid framed by the above lists, populate the cell at the intercept where the longest-term liability (topmost in your list) is applied to fund the longest-lived asset (leftmost in your list).
Â·Â Â Â Â If there is “unspent” liability remaining, use the residual amount of the liability to fund the adjacent asset in the list, and the subsequent asset and so forth until the liability line item is exhausted.
Â·Â Â Â Â If there is “unspent” asset remaining, move below to the next liability and apply it towards funding the remaining amount of the asset.
Keep moving right (to the next asset) and down (to the next liability) until you reach the last item of asset ”“ usually cash & bank balances, being theÂ most liquid ”“ and the last item of liability ”“ usually the immediate payables.
Â Â Â Â Â The last item of liability (or its remaining portion) should fund the residual portion of the last asset ”“ this is a tautological statement since you started with a Balance Sheet that tallied.
It is important to note that we have not attached any duration to any of the individual items of assets or liabilities. This is purely out of practical considerations to keep it a handy exercise and a “doable” proposition, or else you may have to make many assumptions, such as: “What duration do I attribute to shareholders' equity”.
You can decide the level of detail you want to employ in carrying out this study. You could either do it using sub-categories of assets and liabilities (as in groups of accounts of roughly similar maturity profile) or, if you are prepared for the tedium, at the item level of your trial balance.
To overcome the rigours of the exercise, the above logic of iterative apportionment has been incorporated in an excel macro and can be sent to you upon request to the author.
I have found it useful to analyse the output first by column and then by row. This helps see how each asset has been funded, as in, how many sources have been required for funding each asset.
Upon analysing, you may well find that the share capital of the firm and its long-term debts do not cover its long-lived fixed assets. This means that short-duration sources of funds have been deployed to finance longer duration assets. This could lead to a situation where the firm finds itself having to repay the (short-term) sources whilst the corresponding assets have not yet been realised into cash. The risk arising from this mismatch of maturities, is liquidity risk, and carries with it a host of attendant consequences.
The converse also happens, though not as frequently. You may find that the firm is using long-term sources of funds to fund all assets, even short-term assets such as inventories and receivables. This is a case of playing too cautious, where the risk is one of incurring an opportunity cost. In other words, the firm would be better off borrowing to fund the short-term assets and thereby drive up its return on equity, all this without taking on undue liquidity risk.
Of course, it is possible that a certain asset (or group of assets) is financed by a specific funding source, such as project finance, in which case it is advisable to match them off against each other, and study the mismatch characteristics.
I often get asked “How often must we run this health check?” To this I say, for a non-banking entity, daily would be wasting your time, weekly would be utopian, monthly might be ideal, but definitely once a quarter.