Short-term debt as a long-term strategy: Is it sustainable?

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: In recent years, a consistent trend has been observed among some Indian corporates of deploying short-term debt for long-term purposes, to the detriment of their financial risk profiles.

The observation is based on a study of rating changes during the four-year period from 2001 to 2004. Considering that short-term debt is normally cheaper than long-term debt, meeting long-term funding requirements and growth plans through short-term debt has emerged as a superficially attractive strategy in many cases in this study.

This article examines the implications of such a strategy, and demonstrates the negative impact it has on the borrower's credit risk profile. The linkage that emerges between the mismatch in borrowing and deployment timeframes, and rating downgrades, clearly demonstrate that the strategy is not sustainable.

Why corporates have preferred short-term borrowing in recent times

Typically, a company meets its funding requirements from internal generations/own sources, creditors, and borrowings. Working capital funding is usually taken for financing current asset requirements, whereas capital asset creation happens through long-term sources such as term finance. In recent years, there has been a discernible trend of some corporates deliberately funding their long-term requirements from short-term sources, and 'rolling over' this short-term debt to use it more as a permanent source of financing. Considering some of the immediate benefits it offers, this strategy could look attractive because:

• Short-term debt provides an easy avenue for reducing funding cost: Interest costs on short-term funds are typically lower than on long-term borrowings

• Short-term unsecured advances are easily available: The banking system provides easy access to short-term unsecured advances to corporates with good credit risk profiles.

• Short-term debt available at market-determined floating rates makes it an attractive option: Lenders also offer short-term lending at market-determined floating rates on rollover basis at pre-determined intervals. The advantage of floating-rate debt is that there is a chance for the borrower to benefit from a drop in interest rates.

Given these advantages, it is not surprising that short-term debt has proved an attractive route for funding fixed assets for some corporates. However, what looks good in the short term could have distressing long-term consequences.

Let us understand the impact of using short-term debt for long-term purposes:

Short-term positive impact

• Companies would derive interest rate benefits. Due to this, profit after tax (PAT) margins, net cash accruals (NCA), interest cover, and return on capital employed (RoCE) may look favourable