Finance mistake: Investing Short-term Liabilities into Long-term Assets

Now and then people see a problem, and on the other side of the problem lies an opportunity. Very few people are able to see that opportunity. They get excited with the opportunity and think that it would be a great business idea.

Let us assume someone has come up with an idea and he wants to start a business. Again remember when it comes to Finance/Accounting business is treated separately from the business owners. To start a business two kinds of capital is required (1) Intellectual capital (2) Financial Capital. I will not be telling you much about intellectual capital because then it would be wavering from the topic.

Financial capital is nothing but having money to start the business. In other words starting a business requires money. When business needs money, it borrows. It borrows from two sources (1) Insiders – Mainly Owners, business partners and investors and (2) Outsiders – Predominantly from a financial institution like a bank. Now let us see how it appears on a balance sheet.

Balance sheet has two headings – Liabilities and Assets. Liabilities are nothing but source s of funds. Where did the business source its money? Money sourced from insiders is called Share Capital and money sourced from outsiders is called loan.

Assets on the other hand are uses of funds. Where did the business use the money it sourced? Most of the times it is used in acquiring fixed assets. We also discussed that sometimes the business borrows in kind and they are called Current Liabilities. Similarly on the assets side there is Current Assets.

Further simplifying the Balance Sheet in four sections: (1) Share capital and Loans as Long-Term Liabilities (This is called Long-term liability as the business is not liable to pay these within one financial year. Anything payable in a period longer than one financial year is called Long-term Liabilities.) (2) Short-term Liabilities (Current liabilities is the money business is supposed to go out of business within one financial year. Hence they are called Short-term liabilities) (3) Long-term Assets (Fixed Assets) and (4) Short-term Assets (Current Assets).

We did not purchase Land, building and equipments which are fixed assets to sell within one financial year. That is the reason they are called Long-term assets. However, if you are in real-estate business or a car retailer then definitely it would not be classified as Fixed Assets. It would be classified as Inventory under Current Assets. Ideally speaking life of equipment should be equal to life of a loan.

For example, you want to start a taxi business. You are buying a car to use it for five years then take a loan for five tears. This is because you can pay a part of the money earned from the passengers as interest to the bank. That is what should be done.

Similarly, Long-term Liabilities should be invested in Long-term Assets and Short-term Liabilities should be invested in Short-term Assets. But in case of business 1 + 1 is never equal to 2. The client who tells you that he is going to give you business next week may not even give the proposed business even in a month’s time. Also the client who is supposed to pay on the 21^st day may not pay on that day. It might be 22^nd, 25^th, 30^th or even much longer.

What I want to make clear is that there is no ideal situation in Business. In that scenario it is acceptable to invest Long-term liabilities in Short-term assets. Why am I saying acceptable? It is because long-term lenders will ask for their money only after one financial year. If we have invested in short-term assets, we can liquidate (cash) that short-term asset within one financial year. When we have to pay the long-term lenders, we will have the money to pay them.

However it is a crime to invest short-term liabilities in Long-term assets. This is the second common mistake in business. Why? This is because short-term lenders will come for their money within one financial year. If you have invested their money in Long-term assets you will not have sufficient cash to pay the short-term lenders. In this scenario owners are left with only two options: (1) Pay the money from their own pocket or (2) Sell the fixed assets to pay the short-term lenders. Selling fixed assets to pay short-term lenders is the beginning of an end. This is what leads to cash-flow issues.

 

Financial Literacy

Managing finances is a great skill to have. People who can manage their finances are invariably happy. However with complexities in life increasing, more so with financial terms regular brush up of knowledge about finance is required. Many financial firms run literacy campaigns to make people aware about investments and the best use of money.

However it is not so complex. A few things if taken care of will make you a great money manager. Financial literacy is no rocket science, it is about being aware. Just follow some discipline and read regularly and you are good to go.

• Income and Expenses – In financial parlance this is known as budgeting. It is very simple to keep track of your income. Keep an excel sheet with two sheets for every month. One for income which includes regular paycheck, interest earned, dividend that you get from shares and payment from seasonal job or freelancing. In the expense sheet keep daily record of your expenses. Record every penny. It only requires fifteen minute daily to keep track of your expenses. At the end of the month total expenses. You just need to use a simple formula in Excel. If your income exceeds your expenses, put aside the balance as saving. If expenses are more than income observe the expenses which are not so essential and cut down on them. This is the first step towards financial literacy.
• Debt Management – You might have loans on you. Paying the debts on the right time frame will keep your credit record good. Good credit scores are essential if you want to live happily without any hassles. Never collect debt, it will hamper you financial health. Pay off the debts as soon as possible and use credit cards judiciously. The secret to being financially good is to manage debts and never let it accrue.
• Insure and be safe – Insurance is an essential in the present scenario. It keeps your mind clutter free and hedges you against financial risk. At least have one life, one health and one disability insurance. If you own a car be sure to regularly renew the insurance. Insurance is an investment that keeps you safe.
• Instill the saving habit and invest – Get out of the habit of spending all. Save at least 15 percent of your earnings for the rainy days. Set aside some savings for regular investment. It will help you fight inflation.
• Subscribe and read financial newsletter – In the age of the internet it is very easy to learn basic finance. Just subscribe to free newsletters and you will be financially savvy in no time.

The key to financial literacy is to manage your finances well. Keeping these basics and learning new things will help you keep abreast with the movement.