At some point, every small business owner thinks about borrowing money to finance the company's growth, but do you need a short-term or long-term loan? What are the differences between short-term debt vs. long-term debt? What are the advantages and disadvantages of each type? The choice of loan depends on its purpose, current interest rates, the creditworthiness of the borrower and the effect of borrowing on the financial leverage of the company.
Why Do You Need the Money?
The timing of the cash flow conversion cycle from inventory to accounts receivable to cash is not always perfect. Sales volume occasionally takes a dip, and sometimes your clients don't pay their invoices on time. On the other hand, your suppliers expect you to pay their invoices on due dates. Vendors are not quite as flexible when it comes to collecting their money.
A short-term loan is ideal to make up temporary shortfalls in cash flow. To fill these gaps, lenders are usually willing to offer working capital loans secured by inventory or accounts receivable. The loan would be repaid from the conversion of accounts receivable to cash.
What if you want to purchase a major piece of equipment or acquire more real estate to expand production facilities? In this case, you would apply for a long-term loan. Long-term loans are repaid from the operating income of the business, not the conversion of assets as with short-term loans.
Interest Rates for Short-Term Debt vs. Long-Term Debt
Generally, interest rates on short-term loans are lower than rates for long-term loans, but rates can vary with changing economic conditions. This is because lenders consider long-term loans riskier since payments are stretched over several years, and the possibility exists that the company could go out of business before the loan is repaid.
Interest rates on short-term loans are typically quoted at a spread over the bank's prime rate. For example, if the current prime rate is 6 percent, and the loan rate is set up at four points over prime, then the rate for the loan would be 10 percent. However, short-term interest rates can change each time the loan is renewed or rolled over or even with changes in the prime rate during the life of the loan.
Interest rates on most types of long-term debt, on the other hand, are usually fixed for the duration of the loan. Long-term loans have fixed repayment schedules of principal and interest on a monthly or quarterly basis.
What Are the Credit Requirements?
Lenders have different credit requirements for short-term and long-term borrowings.
Since short-term loans are normally secured with inventory and receivables, the credit qualifications are lower. Lenders can rely on the quality of the collateral and expect repayment from the cash conversion cycle of current assets. While your credit rating is a factor, a poor rating will not necessarily prevent you from getting a short-term loan.
Long-term loans, however, are a different matter. Although these loans will more than likely also be secured with the underlying assets, like real estate or equipment, lenders must rely on the borrower to generate income from these fixed assets to repay the loan.
What Is the Effect of Short-Term Debt on the Balance Sheet?
Short-term and long-term borrowings change the financial ratios on your balance sheet. Since short-term debt is usually due within one year, it is included in current liabilities on your balance sheet. This affects the calculation of your company's current ratio and amount of working capital.
Suppose, for example, your company has current assets of $400,000 and current liabilities of $200,000. Your current ratio would be 2:1.
Then, you borrow $50,000 to purchase inventory. Current assets are now $450,000, and current liabilities are $250,000. The new current ratio is 1.8:1 ($250,000/$450,000). It has declined from the original ratio of 2:1.
What Effect Does Long-Term Debt Have on the Balance Sheet?
Long-term debt is a separate category on the liability side of the balance sheet, and the addition of long-term borrowings affects the financial leverage of your company. For illustration, consider if your company does not have any short-term debt but has $300,000 in long-term borrowings and $350,000 in equity. Your debt-to-equity ratio would be 0.86:1 ($300,000/$350,000).
Now, you decide to borrow $200,000 for plant expansion and purchases of equipment. The increased production level will require an additional $50,000 in short-term loans to finance purchases of inventory. As a result, your revised debt/equity ratio increases to 1.6:1 [($50,000 plus $200,000 plus $300,000)/$350,000].
The negative part is that lenders like to see low debt/equity ratios because it gives them more protection. As a result, they might become reluctant to advance more loans to businesses with high debt/equity ratios. The positive side is that the plant expansion will be successful and generate more income, resulting in a higher return on equity.