“We were not taught financial literacy in school. It takes a lot of work and time to change your thinking and to become financially literate.” Robert Kiyosaki
M/S ABC Enterprise is facing a liquidity crisis. The bank has sanctioned them working capital loan. In an emergency, they used the borrowed money by way of working capital loan for buying land and machinery.
Since the money required for working capital was used for buying assets, they started to face a liquidity crisis in 3 months. They approached their banker. The banker asked for the financial data.
From the financial data, the banker found that the working capital money was used for buying assets. The bank observed that;
- The key ratios were affected.
- The current ratio which is the key ratio to determine the liquidity was below the acceptable level.
- Since the working capital was blocked their sales were also affected.
- Since the sales were down their current assets i.e. stock and receivable were down. This has resulted in lower working capital drawing power.
- The assets were purchased before 6 months, the bank declined to refinance the assets.
- Since the working capital loan was used to buy non-working capital assets, it was classified as fund diversion. The bank asked them to recoup the working capital gap by raising additional capital.
- Failing to raise additional capital would entail recall of working capital loan.
The owner of ABC Enterprise was in a soup. He was in a dire financial situation.
- His investment in additional assets could not generate any income without additional working capital.
- His existing business suffered due to inadequate working capital as part of which was blocked in buying new fixed assets.
Handpicked related post: CCC is the Ratio Every SME Needs to Focus On
He wondered what did he do wrong? This is what many entrepreneurs suffer from. They do not realise the difference between the monies in their account.
Money in your account has a specific purpose. If the money is used for a different purpose, things can go haywire.
Working Capital Loan:
Working capital money is for short-term purpose. This is given against stock and receivables. Usually, for any business stock and receivables turn around within 6 months. This way working capital is released and recycled every 6 months.
Term loans are given by the bank to buy fixed assets. These loans are for a longer tenure. Its repayment is designed based on the cash flow it could generate over the period of time. The tenure usually is 3 to 7 years.
Handpicked related post: 8 Things You Need to Know to Deal With Financial Distress
When fixed assets are purchased, they can usually have a payback period of 3 to 7 years. The money used to finance these assets remains blocked for 3 to 7 years.
Therefore, if you have borrowed money with a repayment tenure of 1 year to buy fixed assets, you are likely to face a liquidity crisis. After one year you need to pay back the loan, but you have blocked the money for 7 years.
Now what you would do is, paying from your short-term liquidity. But this short-term money is available for working capital recycle. This will hamper your liquidity.
This is what happens when you used the working capital loan to pay for busying fixed assets. The working capital loan tenure is usually 1 year and renewed every year.
Before the renewal, the entrepreneurs would know the liquidity crisis or on renewal, the bank would know the liquidity crisis and fund diversion from the financial data.
Credit: https://corporatefinanceinstitute.comWhen long term assets are financed by a short-term loan this is called asset-liability mismatch.
Current Assets can be financed by any kind of money but Non-Current Assets shall not be financed by Current Liabilities.
Asset Liability mismatch is a major cause of the financial crisis. Your good business can suffer from this wrong decision. If there is any loan repayment default due to the liquidity issue, the credit rating is severely impacted.
“The number one problem in today’s generation and economy is the lack of financial literacy.” Alan Greenspan
Handpicked related post: Dear Entrepreneurs, Cashflow Is Not Your Money
The recent crisis of IL&FS was due to the asset-liability mismatch according to one of the board members.
Remember all money is not equal. All money has a specific purpose. Knowing the difference would be a sound insight for every entrepreneur.
You may also like to read: Why Do Entrepreneurs Need to Save for Personal Obligations?