«Determinants of short-term debt financing Richard H. Fosberg William Paterson University ABSTRACT In this study, it is shown that both theories put ...»
111008 – Research in Business and Economics Journal
Determinants of short-term debt financing
Richard H. Fosberg
William Paterson University
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 short-term debt financing is shown to be inversely related to the amount of the firm’s non-debt tax shields, growth opportunities, product uniqueness and firm size. Additionally, short-term debt financing was found to be directly related to the quantity of tangible assets the firm owns.
Keywords: Debt, Capital Structure, Matching Principle, Collateral, Financing Determinants of short-term, Page 1 111008 – Research in Business and Economics Journal
INTRODUCTIONThe matching principle of finance is the standard theory used to explain the amount of short-term debt financing and other current liabilities that a firm has on its balance sheet.
Briefly, the theory states that firms should finance their short-term assets with short-term liabilities (Guin (2011)). This implies that the amount of short-term debt financing that a firm uses depends on the amount of the firm’s short-term assets and its other sources of short-term financing. However, since short-term debt has characteristics that are similar to the characteristics of long-term debt, the factors that have been shown to affect the amount of longterm debt financing that a firm uses may also affect the amount of short-term debt financing a firm employs. 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 THEORYAccording 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 Determinants of short-term, Page 2 111008 – Research in Business and Economics Journal sources of financing then the firm’s short-term financing choice variable is short-term debt.
Accordingly, the matching principle implies that a firm should adjust its short-term debt financing until the amount of the firm’s current liabilities equals the amount of its current assets.
Defining other current liabilities (OCL) to be all current liabilities except short-term debt (STD), then the amount of a firm’s short-term debt should be equal to the amount of its current assets less other current liabilities (STD = CA – OCL). The matching principle thus implies that a firm’s short-term debt financing should vary over time as the amount of the firm’s current assets and other current liabilities change. This implies that there are at least two ways that a firm’s short-term debt financing can change. One is if firm size changes. For example, if a firm grows the amount of its current assets will likely increase as well. To maintain the CA = CL equality, if current assets increase then so must current liabilities. An increase in spontaneous current liabilities is likely to account for part, but not all, of the increase in current liabilities.
Consequently, the firm will have to increase the amount of its short-term debt financing as well.
Conversely, if the firm’s current assets decrease the amount of its short-term debt financing and other current liabilities should decrease also. This will be called the size effect on short-term debt and implies a direct relationship between short-term debt financing and the firm’s current assets balance.
A second source of change in a firm’s short-term debt financing may exist if short-term debt and other current liabilities are substitute forms of short-term financing. Holding current assets constant, if the amount of a firm’s spontaneous current liabilities increases the firm will have less need for short-term debt financing to finance its short-term assets. Conversely, if spontaneous short-term financing decreases the firm will need to increase the amount of its shortterm debt financing. This will be called the substitution effect and implies an inverse relation between short-term debt financing and other current liabilities. In a regression with short-term debt as the dependent variable and current assets and other current liabilities as explanatory variables, the size effect implies that the coefficient of current assets should be positive while the substitution effect implies the coefficient of other current liabilities should be negative.
Additionally, short-term debt could be used as permanent source of financing if the debt is continually refinanced as it matures. One reason to use short-term debt as a permanent source of financing is to take advantage of an upward sloping yield curve to reduce the firm’s interest expense. When the yield curve is upward sloping, as it usually is, the interest rate on short-term debt is lower than the interest rate on long-term debt. Thus, using short-term debt as a long-term source of debt capital financing should reduce the firm’s interest expense. There are, however, at least two sources of risk associated with continually refinancing short-term debt. One is default risk. If for one reason or another, lenders do not wish to refinance the firm’s debt when it matures, the firm will be in peril of default if sufficient capital is not available to retire the debt.
The other risk is the risk that the interest rate charged on the refinanced debt will rise and cause the firm’s interest expense to rise. Both the default risk and the interest rate risk are continuing risks that a firm faces every time it refinances its short-term debt. The sum of these two risks will be called refinancing risk. If the firm feels that the interest expense savings are large enough to compensate for the refinancing risk incurred the firm may be willing to use continually refinanced short-term debt as a permanent source of financing. If not, long-term debt could be used to finance a firm’s permanent current assets. That is, if a firm found the refinancing risk associated with rolling over its short-term debt unacceptably high, they could reduce the risk by substituting long-term debt financing for the continuously refinanced short-term debt. The disadvantage of doing so would be to increase the firm’s interest expense.
Determinants of short-term, Page 3 111008 – Research in Business and Economics Journal The second theory of short-term debt determination tested here is that the factors that have been shown to affect the amount of long-term debt financing that a firm employs also affect the amount of short-term debt financing a firm uses. For example, the interest paid on both short-term and long-term debt is a tax deductible expense that generates a tax saving (interest tax shield) for the firm. Other tax shields that can reduce the value of the interest tax shield, like depreciation and amortization expense, have been shown to reduce the amount of long-term debt financing that a firm uses. Since depreciation and amortization expense would also reduce the value of the interest tax shield generated by short-term debt, they might also affect the amount of a firm’s short-term financing. Other factors that have been shown to affect the amount of longterm debt financing that a firm employs will be discussed below. See Fama and French (2002) and Flannery and Rangan (2006) for a detailed discussion of the factors that affect long-term debt financing.
An empirical examination of the factors that affect the amount of short-term debt financing that a firm employs is conducted as follows. For each year from 2001 through 2007 an initial sample of firms was taken from all firms listed on the current and research files of the COMPUSTAT data base. Firms in the financial services or utilities industries were excluded from all annual samples. Companies with non-positive book value of common equity, negative values for short-term debt and current liabilities to current assets ratios of five or better were also excluded from the annual samples. To be included in the initial sample for a year a firm must have sufficient data available to calculate the firm’s book and market short-term debt ratios. A firm’s book short-term debt ratio (BSDR) is defined to be short-term debt divided by total assets.
Short-term debt includes short-term loans and commercial paper. A firm’s market short-term debt ratio (MSDR) is defined to be book short-term debt divided by the market value of the firm.
Firm market value is calculated as total assets less book common equity plus market common equity (common shares outstanding times share price). This procedure yielded initial annual sample sizes ranging from 4,358 to 5,250 firms. Table 1 contains the mean values of selected variables for the sample firms for three sample years. Looking at the short-term debt ratios, it is apparent that firms are using less short-term debt financing than they have in the past. The mean BSDR declined from 2.9% in 2001 to 2.0% in 2007 while the mean MSDR declined from 2.5% to 1.2% over the same period. This is confirmed by looking at the mean dollar value of firm short-term debt, which declined from $142 million in 2001 to $106 million in 2007. Mean longterm debt financing however increased markedly over the sample period, rising from $458 million in 2001 to $744 million in 2007.
Another interesting fact revealed by the data is that mean current liabilities is significantly less than mean current assets in each of the sample years. Additionally, the mean current liabilities divided by current assets ratio has remained fairly stable over the sample period varying between 57% and 59%. That is, firms are only financing 57% to 59% of their current assets with current liabilities. A matching principle interpretation of this result is that, on average, firms view 41% to 43% of their current assets as long-term assets that should be financed with long-term liabilities. This should be viewed as a lower bound on the percentage of current assets that are being financed with long-term liabilities as firms could be using permanent amounts of short-term debt to finance some of the current assets. Another fact revealed by the data is that the average sample firm has experienced significant growth over the sample period as Determinants of short-term, Page 4 111008 – Research in Business and Economics Journal mean total assets increased from $2,351 million in 2001 to $3,979 million dollars in 2007. Cash holdings, which include currency, bank deposits and short-term marketable securities, doubled over the sample time period. This growth is mirrored in the mean values of all the other variables in table 1 (that are not ratios) except short-term debt.