Difference Between Long-Term & Short Term Sources of Financing

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Do you need a loan for your business? For what purpose will you use the money? Are short-term funds necessary to cover a temporary working capital deficit? Or are you thinking about buying better machinery for the production line? Several factors determine the type of loan required.

What Do You Need the Money For?

When borrowing money, the repayment terms of the loan should match the purpose of the funds. Short-term loans up to 12 months are generally used to fill in temporary cash flow deficits. Examples here include bank overdraft facilities, credit cards and other lines of credit which you can use to get you through the slow months of a seasonal business. Long-term loans are repaid over multiple years and are generally used to finance purchases of fixed assets such as real estate, buildings, equipment and vehicles.

How Will You Repay the Loan?

Short-term loans are used to make up fluctuations in a company's cash flow cycle of current assets. For example, a business might use its bank line of credit to finance the purchase of raw materials for inventory. These raw materials make products to sell. The sales become accounts receivable, and the customers pay their invoices at due dates. The business uses the cash from the collection of receivables to repay the loan at the bank. The process would start over when the company borrows again from the bank to buy more raw materials.

Long-term loans, on the other hand, are repaid out of the company's free cash flow from operations, not from the conversion of assets like a short-term loan. These loans are repaid over a period of years. A loan to invest in new equipment might be repaid over three-to-seven years. Real estate loan payments are spread over 15-to-30 years.

How Creditworthy Are You?

The application and qualification standards are more stringent for long-term loans as compared to short-term. Because the repayment of a long-term loan takes place over several years, a lender has to consider the increased risk that the borrower will stay in business and be able to make the payments. If some type of collateral secured the loan, the condition of the security could deteriorate over time and reduce the lender's margin of safety.

Short-term loans are easier to get than long-term loans because the repayments terms are shorter and the security of inventory and receivables is much simpler to evaluate. A lender has less risk in a short-term loan, so the approval process is less complicated.

Can You Afford the Interest?

Short-term loans typically have interest rates quoted at a few percentage points over the current prime rate. For example, if the prime rate is 4 percent, a bank might offer a rate of prime plus two percentage points. This figure could fluctuate over the life of the loan, and each cash advance under a line of credit would have a different interest rate. Long-term loans usually have a fixed rate over the entire term of the loan. Payments are fixed monthly amounts of principal and interest.

Some types of long-term financing do not come from debt at all, but from equity. For example, a company might sell shares in the company to raise the capital it needs to grow. While there are debt repayment obligations with this type of financing, you are giving away ownership in the company. This can impact your ability to make decisions and the shareholders are entitled to receive a percentage of the company's profits as a dividend on the shares they own.

References

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.