8.4 Alternative Capital Structures: Matching and Mismatching Assets and Capital Funds

Well, we have not solved the question of what is the optimal (vertical) capital structure? – and we won’t! There really is no universal optimal structure, that is to say, for the ratio of debt to equity – since debt and equity are both on the same side of the Balance Sheet, we might refer to this type of capital structure as “Vertical.” The actual level of leverage a company takes on will depend on numerous factors including the state of the financial markets, the company’s industry and sector, and both management and shareholder risk profiles.

Some industries can tolerate, or not tolerate, a higher, or lower, interest burden given the stability, or lack thereof, in its EBIT or EBITDA; the greater the stability in its (operating) cash inflows, the greater the tolerance, objectively speaking, for leverage.  For example, an electric utility company can tolerate high leverage because its cash flow is relatively stable. It can live with a lower TIE ratio. There is another way of looking into Capital Structure.

Herewith we shall discuss a related issue beyond the leverage ratio itself, that is, the internal composition of debt and equity relative to the firm’s assets’ composition, and in connection with corporate risk profiles. Let us discuss Horizontal Capital Structure – matching up the left and right-hand sides of the Balance Sheet.

It stands to reason that a financial manager would want to match up the timing of the firm’s cash receipts and payments. When you need to make payments, you want to have funds coming in. One would think, therefore, that the firm would want to match up short-term assets with short-term financing sources (liabilities), and similarly long-term assets with long-term capital sources (debt and equity). In this way, assets would “turn over” when the liabilities come due. Funds would be available when needed. Having noted this incentive, a company, nonetheless, may have reason to “mis-match” the timing of its assets and liabilities as we shall soon see.

The following graph depicts how the corporate financial manager, who is concerned about financing sources to fund growth, may look at the Balance Sheet. Note the difference of this view in comparison to the accounting presentation. How would you engage the Matching Principle? How – and why – might you mismatch? Read on!

The manager in the table just above may be viewed as displaying a conservative risk profile. S/he would match short-term assets with short-term capital funds and long-term with long-term. This way, when the money is due, there will be assets that have turned over to provide liquidity. Is there an incentive for a more aggressive corporate financial manager to mismatch?

In a normal environment, long-term interest rates will be higher than short-term rates. In other words, the yield curve will be positively inclined and returns on stock will also be higher than short-term rates. Financial managers thus will have cause to finance long-term assets with short-term funds in order to reduce overall financing costs (the WACC). This, of course, increases the firm’s financial risk due to faulty timing. And the actual matching decision the corporation makes emanates from the risk profile of the firm’s management and thus its shareholders. How much risk are management and shareholders inclined to take on in the name of producing greater profits, which is to say, from a non-operating, purely financial, point of view? This is the extent to which the firm will mismatch its assets and capital. This may be a viable strategy if the firm’s operating cash flow is growing thereby substituting for the illiquidity of the long-term assets.

Hence, once again, as firms’ managements become more aggressive, they may increasingly mismatch their capital structure (i.e., assets relative to capital) in order to lower overall financing costs. (This may or may not entail greater overall – Vertical -leverage.)  The following presents some, but not all, possible structural combinations. This illustration is not intended to be a factual, or even a conceptually perfect representation; take it with a grain of salt!