What is a Shortfall
A shortfall is an amount by which a financial obligation or liability exceeds the amount of cash that is available. A shortfall can be temporary, arising out of a unique set of circumstances, or it can be persistent, in which case it may indicate poor financial management practices. Regardless of the nature of a shortfall, it is a significant concern for a company and is usually corrected promptly through short-term loans or equity injections.
BREAKING DOWN Shortfall
A shortfall can refer to a current situation as well as one predicted for the future. A shortfall applies to any situation where the level of funds required to meet an obligation is not available. Shortfalls can occur in the business arena as well as to individuals. Temporary shortfalls often occur in response to an unexpected event, while long-term shortfalls may be related to overall business operations.
A temporary shortfall for a small company may arise when an equipment failure at its production facility impedes output and results in lower revenues in a particular month. In this case, the company may resort to short-term borrowing to meet payroll and other operating expenses. Often, once the issue that led to the shortfall is corrected, business operations return to normal, and the shortfall is no longer a concern.
In the consumer market, an escrow shortfall may occur when the amount of funds deposited into the escrow account, often paid along with a mortgage payment, do not meet the obligations associated with the escrow funds, such as property taxes or homeowner’s insurance. In these cases, consumers are notified of the shortfall and may be presented with the option of paying the entire amount at once or by increasing the monthly charge associated with their mortgage payment to cover the difference.
A typical long-term shortfall is the pension shortfall faced by many organizations whose pension obligations exceed the return they can generate from their pension assets. This situation generally occurs when returns from equity markets are well below average.
For example, in 2015, the state of New Jersey’s pension fund, a defined benefit retirement plan, was considered underfunded. If the contribution rate was not raised, it could result in a shortfall in the pension account. In response to the shortfall threat, government officials propose possible solutions, such as raising revenue through new taxes or redirecting funds from cuts in other areas to attempt to bring the fund up to a sustainable level.
Shortfall Risk Mitigation
Shortfall risk can be mitigated using efficient hedging strategies, which aim to offer protection from adverse price movements. As an example, resource companies often sell part of their future output in the forward market, especially if they are expecting to incur substantial capital expenditures in the future. Such hedging helps to ensure that the finances required for a future financial obligation are available.