Misfinancing, as a concept, is simply trying to describe whether the proper form of debt has been used to purchase a given asset.
The quick explanation:
Is long term debt (loans etc.) used to purchase long term assets (buildings, major equipment etc.)?
Is short term debt (credit cards etc.) used to purchase short term assets (inventory etc.)?
If yes: Then congratulations, everything is as it should be!
If no: That's OK, mistakes happen. Here's your chance to improve your business by making sure that you follow these guidelines moving forward.
- Use Long Term Debt to Finance Long Term Assets
- Use Short Term Debt to finance Short Term Assets
Possible Hazards of Misfinancing:
- Overuse of Profits
- Short Term Loan - Large Loan Amount
- High Interest Rates
- Lack of Solvency
- Potential Bankruptcy
The long explanation:
The type of debt (short or long term) that is used to purchase a given asset should match the useful life of an asset. For example, you wouldn't purchase a building or a major piece of equipment (tractor) on a credit card (short term debt). Nor would you take out a long term loan to purchase a shipment of goods. These goods are only going to be around for a short period (until you sell them). Then, of course (as a responsible business owner), you would use the money generated from those sales to pay back the short term debt. Conversely, a long term asset is going to take much longer to actually produce the money that will be used to pay it off. Therefore should be on a longer term loan.
Ideally, if a business's finances are organized in the optimal way, the type of debt used will match the type of asset it's used for.
When our software sees that the number representing the value of Gross Fixed Assets plus Retained Earnings is much higher than the long term debt, it thinks "Hey, I think that you've potentially used some short term debt to pay for long term assets, and that's not the best way to structure things. I'd take a look at that if I were you".