Final answer:
Short-term debt for temporary working capital comes with inherent risks, such as potential liquidity issues due to mismatched maturities. However, it can be profitable if the return from the financed assets exceeds the borrowing cost.
Step-by-step explanation:
Short-term debt is commonly used to finance temporary working capital needs in businesses. While short-term debt can provide quick access to funds, it also comes with certain risks and considerations.
Risk: When temporary working capital is financed with short-term debt, there is a risk of mismatched maturities. Short-term debt typically has a repayment period of one year or less, whereas temporary working capital needs may extend beyond that timeframe. If the short-term debt cannot be renewed or refinanced when it matures, it could lead to liquidity issues for the business.
Profitability: Short-term debt can be profitable for temporary working capital if the return generated from the assets financed with the debt exceeds the cost of borrowing. For example, a business may take a short-term loan to purchase inventory for a seasonal peak in demand. If the increased sales generated by the inventory outweigh the interest expense of the loan, it can result in profitability.