What it means
Finance people use the word whenever the money coming in does not line up with the money going out. The gap can be about when cash arrives, which currency it is in, or how sensitive it is to changes in interest rates.
The most familiar type is a maturity mismatch, sometimes called a funding gap. A business that borrows on a 90-day facility to build a factory that will take ten years to pay back must refinance again and again, and it is in trouble if lenders decline to roll the loan over.
A currency mismatch arises when income is in one currency and debt is in another. A company that sells in its local currency but repays a loan in US dollars loses out when the local currency weakens, because every repayment suddenly costs more local money.
An interest rate mismatch happens when assets and liabilities reprice at different times. A lender holding fixed-rate loans that are funded by floating-rate deposits sees funding costs jump when rates rise, while its income stays the same until the loans mature.
Banks, insurers and pension funds manage this formally through asset-liability management (ALM, the discipline of measuring and controlling the gaps between what a firm owns and what it owes). Corporate treasurers use simpler tools: cash forecasts, matching loan terms to the life of the asset being financed, and hedging with forward contracts or swaps.
Some mismatch is deliberate and even profitable, since banks earn much of their margin by lending for longer than they borrow. The danger lies in mismatches that nobody measures or that are too large for the firm's capital and cash buffer to absorb.
In practice
Real-world examples.
Example
A property developer funds a five-year apartment build with a 12-month bridging loan. When the loan falls due the apartments are only half sold, and the developer has to accept a higher interest rate to extend it.
Example
An exporter of handmade furniture invoices customers in local currency but buys its timber with a loan denominated in US dollars. When the local currency falls 15% against the dollar, the loan costs far more to service and profit disappears.
Example
A regional bank funds fixed-rate home loans with deposits that can be withdrawn on demand. When market rates rise, depositors move their money to better rates and the bank must pay more to keep its funding.
Formula
Calculation
Funding gap = Assets maturing within the period - Liabilities maturing within the period
Coverage ratio = Assets maturing within the period / Liabilities maturing within the period
A company expects $2,000,000 of cash and receivables to come in over the next 12 months, while $3,500,000 of debt falls due in the same period. The gap is $2,000,000 - $3,500,000 = -$1,500,000. The coverage ratio is $2,000,000 / $3,500,000 = 0.571, so only about 57 cents of each $1 due is covered by incoming cash, and the company must refinance, raise equity or sell assets to close the remaining $1,500,000.Case study
Seen in the real world.
Tidewater Apparel is an illustrative, fictional clothing importer that bought stock using a $1,200,000 overdraft which the bank could cancel on 30 days' notice. Its customers, however, took 90 days to pay, so the company was permanently waiting on cash it had already spent.
When the bank reviewed its lending policy and reduced the overdraft limit, Tidewater found it could not pay suppliers on time. The finance director calculated a funding gap of $400,000 across the following quarter and recognised that the business had been growing on short-term money to finance slow-moving receivables.
The fictional fix had three parts: a three-year term loan for the permanent part of working capital, a receivables financing line, and a rule that every new borrowing had to match the life of what it paid for. The business grew more slowly for a year but stopped lurching from one funding crisis to the next.
Watch out
Common mistakes.
- Assuming a profitable business cannot have a funding problem, when profit and cash timing are different things.
- Measuring only the total amount of debt and ignoring when each piece falls due.
- Hedging a currency exposure for a single year while the underlying loan runs for ten, which leaves the later years unprotected.
Questions
People also ask.
What is a maturity mismatch?
It is a gap between when a firm's assets turn into cash and when its liabilities must be paid. The wider the gap, the more the firm depends on lenders continuing to refinance it.
Are all mismatches bad?
No, banks and insurers take managed mismatches to earn a return, but they set limits and hold buffers. The problem is an unmeasured or oversized mismatch.
How do you fix a mismatch?
Lengthen the funding, shorten the assets, hold a cash reserve or use derivatives such as forwards and swaps. The right mix depends on cost, tax and what lenders will offer.
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