Short Term and Long Term Financing for Business
A company, just like any person, sometimes needs additional money to operate and grow. Businesses seek external financial capital for many reasons, including managing cash flow, developing new products, replacing equipment, expanding operations, purchasing inventory, or increasing sales. Most business funding falls into two broad categories: loans (debt financing) and equity financing.
Business loans are similar to personal loans because they must be repaid with interest. Interest is a business expense, and the larger the loan or the higher the interest rate, the more expensive borrowing becomes. Equity financing involves selling ownership shares in the business to investors in exchange for capital. In return, investors become part owners and gain a claim on future profits and, in many cases, some control over business decisions.
A corporation has two different broad types of financing available; short and long-term. Equity and debt financing are the most commonly referred to, but both are forms of long-term financing.
Short-Term Financing
There are numerous ways a firm can borrow funds to satisfy its short-term needs, but the most common ways are through unsecured and secured loans, commercial paper, and banker’s acceptance.
New and established businesses often use short-term financing to manage cash flow. Revenue is not always received when expenses are due, so businesses may borrow money to pay employees, suppliers, rent, or other operating expenses until customer payments are collected.
Bank Loans
There are two types of bank loans – Secured and Unsecured. While the main difference is collateral, there are some other important distinctions as well.
Established businesses, typically those that have been operating for at least two years and can demonstrate consistent revenue and the ability to repay debt, are often able to obtain business loans from banks. These loans may be used to cover short-term operating needs or finance larger long-term investments.
Unsecured Bank Loans
An unsecured bank loan is a loan in which the borrowing firm does not provide any assets as collateral. Therefore, the bank is taking on default risk if the borrowing firm doesn’t repay the interest or principal. These are loans provided by a bank that can be either committed or non-committed.
With a committed bank loan, usually used if the firm is borrowing from a bank for the first time, the firm must file legal paperwork with the bank that determines the amount the firm can borrow. A non-committed loan allows the firm the ability to borrow up to a certain amount of funds, usually up to the amount previously borrowed, without having to file the legal paperwork.
Secured Bank Loans
A secured loan is a loan in which the borrowing firm provides assets as collateral. This way the bank is assured that it will be repaid if the firm defaults on the loan. Common forms of security, or collateral, may be inventory, accounts receivable, or other liquid assets.
A firm would choose a secured loan over an unsecured loan because the bank will provide a lower interest rate if the loan has collateral attached to it. That being said, the firm runs the risk of having its assets provided as collateral seized in the case of a loan default.
Commercial Paper and Banker’s Acceptance
Other forms of short-term financing include commercial paper and banker’s acceptance.
Commercial Paper
Commercial paper is a debt instrument in which a firm issues an IOU to a bank, company, or wealthy individual, which provides funds to the firm. It typically makes up notes payable in current liabilities. Commercial paper has a maturity of 270 days or less, which exempts it from being registered with the SEC, providing an easy transference of funds.
Banker’s Acceptance
A less common way for firms to receive short-term funds is through banker’s acceptance. This occurs when a seller sends a bill to the customer’s bank, which agrees to pay that bill. Of course, the firm will eventually need to pay the bank back with interest.
Both types of loans provide the firm with quick, easy cash that doesn’t require the type of legal contracts that come with bank loans. Commercial loans are relatively safe investments since firms with high credit ratings issue the loans, and due to the short period of time the loan is outstanding, the financial health of the firm is easily predictable. Banker’s acceptance is an easy way to “borrow” funds since the firm doesn’t have to repay the bank immediately. Both options are used due to their ease.
Long-Term Financing
Long-term financing is generally divided into debt financing and equity financing. Businesses use long-term financing when they need funds for investments that will provide benefits over many years. Established businesses often seek external capital to develop new products, replace aging equipment or facilities, expand operations, and increase sales volume and revenue.
Stock
The most common type of long-term financing used by corporation is by issuing stock. Stock has two types – Common and Preferred, both types have advantages and disadvantages.
Common Stock
Common stock is the most common form of equity financing. Equity financing raises money by issuing ownership shares in a company to investors. In exchange for providing capital, investors become part owners of the business, gain voting rights on certain corporate decisions, and have a claim on future profits. It is important to note that the company only receives funds when the shares are first issued. Once the shares are sold, future trades between investors do not provide additional money to the business.
Common stock is what is normally trading on stock exchanges.
Preferred Stock
Preferred stock has components of debt and equity in that is pays a fixed dividend regularly, has priority over stockholders, and trades like stock. The payments are predictable and can be written off the tax statement. Why is preferred stock less popular among investors? It is less popular than equity because the rate of return is lower than that of stock, and less popular than bonds because bonds typically have a higher coupon rate.
Debt (Bonds)
Debt is a fixed income security that pays periodic interest, but doesn’t represent ownership in the company. As a brief overview, a firm issues a bond to individuals with varying maturity dates, quoted above, below, or at a fixed value called par. The firm receives money from the investors in the amount of principal paid at the time for the bond. Debt is attractive to corporations because the interest payments made can be deducted from the company’s taxes, lowering the amount it pays. Plus, the payments made are easily predictable and fixed. However, issuing debt increases the number of people who must be paid regularly, regardless of the company’s financial performance. One of the most important reasons a firm chooses debt over equity, though, is that debt provides a firm with financial leverage.
Like other business loans, corporate debt must be repaid with interest. Interest payments are considered a business expense and reduce taxable income. However, larger loans or higher interest rates increase the overall cost of borrowing, so businesses must carefully balance the benefits of borrowing against the additional costs.
Financial Leverage
The biggest reason companies use debt is for financial leverage. Financial leverage is simply the use of debt to purchase assets. A firm that borrows funds by issuing debt will, in effect, have extra cash that it can use as it wishes. This is akin to a credit card. For example, a firm can use $200,000 to buy equipment by using its cash, or it can multiply that $200,000 by borrowing additional $400,000 to buy $600,000 worth of equipment. While this allows firms the ability to use more cash than it has on hand, it comes with significant risk. The more the firm borrows, the more interest it will owe on outstanding debt. While this will lower the amount of taxes the firm must pay, the firm cannot neglect interest payments, which needs to be paid out regularly. The firm must strike a good balance between using cash on hand and leverage so that it benefits without too much added risk.
The Short and Long-term Financial Needs of a Business
A firm has two different ways it can finance itself; short and long-term financing. How does the firm decide which to use? Is one better than the other? The answer is found on the balance sheet.
Current assets are financed with short-term borrowing (current liabilities), and noncurrent assets with long-term borrowing (noncurrent liabilities). For example, accounts receivable needs to be financed because when a firm sells from inventory on credit, it will not actually receive the funds immediately. There is a stretch of time between the date of the sale, and the date the funds are received. Therefore, the firm needs to cover this temporary deficit with money.
Short-term financing is used in this case because it is relatively simple to borrow on the short term, and it is received by the firm quickly. Also, it is relatively easy to pay off debt in the short term. On the other hand, if a firm is building a new factory, this requires long-term financing. Long term financing is more attractive for very big investments that take a long time to pay off.
Businesses also use short-term financing when cash flow is uneven. For example, a business may need to pay employees and suppliers before customers have paid their invoices. Short-term financing helps bridge this temporary gap between expenses and incoming revenue.
For example, consider the massive capital required for today’s technology infrastructure. Google recently announced a $25 billion investment to build and expand its data centers. It’s impractical for a single financial institution to provide a loan of this magnitude. Instead, this type of long-term investment is typically funded by issuing corporate bonds, which allows the company to borrow from a vast pool of global investors, with each contributing a fraction of the total needed to finance the project.