Intro Business

The Advantage of Current Liabilities: Return

Flexibility

Current liabilities offer the firm: a flexible source of financing. They can be used to match the timing of a firm’s needs for short-term financing. If, for example, a firm needs funds for a month period during each year to finance a seasonal expansion in inventories, then a 3-month loan can provide substantial cost savings over a long-term loan (even if the interest rate on short-term financing should be higher). The use of long-term debt in this situation involves borrowings for the entire year rather than for the period when the funds are needed, which increases the amount of interest the firm must pay. This brings us to the second advantage generally associated with the use of short-term financing.

Interest Cost

In general, interest rates on short-term debt are lower than on long-term debt for a given borrower. For a given firm, the term structure might appear as follows.

LOAN MATURITY INTEREST RATE

3 months 4.00 %

6months 4.60

1 year 5.30

3 year 5.90

5 year 6.75

10year 7.50

30year 8.25

Note that this term structure reflects the rates of interest applicable to a given borrower at a particular time. In would not, for example, describe the rates of interest available to another borrower or even those applicable to the same borrower at a different time.

The Disadvantage of Current Liabilities: Risk

The use of current liabilities, or short- term debt, as opposed to long-term debt subjects the firm to a greater risk of illiquidity for two reasons. First,...