Liquidity: The ability to pay your bills when they come due. (Liquidity actually has two meanings, depending on the context. The definition given in the 1st sentence is the use of the word in the corporate finance arena. In investments, liquidity means the ability to convert your investment into cash easily; i.e., the ability to sell it without having to drop the price to find a buyer. The corporate finance definition is the one used on this page.
Profitability: Revenues minus costs; frequently expressed as a percentage of some other number (e.g., profit/sales, profit/equity, etc.).
Working Capital: The term as used here is Gross Working Capital. It is simply a synonym, or another name, for Current Assets. (The term Net Working Capital is Current Assets minus Current Liabilities; it is a measure of the company's liquidity). The term used on this page refers to gross working capital: another name for Current Assets.
The Matching Principle states that short-term assets (current assets) should be financed with short-term liabilities (current liabilities) and that long-term assets (fixed assets) should be financed with long-term sources of financing (long-term debt, preferred stock, and common equity). (Let's assume the following balance sheet values, in millions of dollars.)
This seems simple enough ... and logical too. After all, you wouldn't finance this week's grocery store purchases with a 30-year bank loan. You don't want to be paying interest on the grocery purchase long after the groceries are gone. You also wouldn't expect a farmer to buy a new tractor and finance it with a 30-day bank loan. After all, the tractor won't generate enough money to pay for itself over a 30-day period.
The problems that we create by violating the principle are pretty predictable.
If we finance the purchase of a new building with a 30-day bank loan, we will likely have trouble paying off the loan in 30 days. The building will not generate enough cash during that time to repay the loan.
A retail store may buy Christmas-related inventory in September, leading up to the holiday season. The store finances this purchase with a 20-year bank loan, with payments to be monthly. The store owners will end up paying interest year-round, even though the money is invested profitably only part of the year.
Let's paraphrase what the Matching Principle says: permanent (or long-lived) assets should be financed with permanent sources of financing; everything else should be financed short-term. But what are permanent assets? Let's take a closer look.
Fixed assets are obviously relatively permanent, or long-lived; but what about current assets? Actually, part of the current assets may be relatively permanent also. Think about any retail store, like a grocery store or furniture store chain. Do the owners of these stores ever want to run completely out of inventory, so the stores are completely empty of inventory? Of course not. There is always some minimum level of inventory that they always want to be out there on display and available for sale.
Let's compare the current assets of a company over a five year period. Assume that these values are $25 million, 28 million, 31 million, 27 million, and 32 million. Conservatively, we could say that the minimum value of $25 million is the amount of inventory (and other current assets) that is always there - i.e., it is the permanent portion of current assets.
Is this amount of inventory really temporary or permanent? Part of the confusion is the terminology that the accounting profession assigns to these accounts: current assets, or assets that will be disposed of within one year or less. Actually, before these assets were called current assets, the accounting profession called them circulating assets. Accounts receivable and inventory circulate through the company - they are on the books for a short while, then are removed and replaced by others. So they are current in that sense.
However, from a financing standpoint, the need for financing the minimum investment in current assets is more permanent than temporary - because this amount of current assets is always in the company. So we can argue that this portion of current assets should be financed with a long term financing source.
Example: Assume that a company has total assets of $100 million, broken down as follows: $15 million in fluctuating (seasonal) current assets, $25 million in permanent current assets, and $60 in fixed assets. The proper way to finance the company is to finance the $15 million in fluctuating current assets with $15 million in current liabilities. The remainder of the assets (i.e., the $25 million of permanent current assets and $60 million of fixed assets) should be financed with long-term sources, as follows:
This provides the company with more liquidity, yet the practice is consistent with the matching principle. Permanent assets should be financed with permanent sources of financing; everything else should be financed short-term.