When is short-term and long-term financing appropriate?
As a small business owner or aspiring entrepreneur, you probably need financing to grow your business. It is important to understand the two different types of financing available and when each is appropriate. The two main forms of financing are short-term and long-term financing.
Short term financing
Short-term financing, with a maturity of 12 months or less, is used to finance current assets. This type of financing would most likely be used to fund an increase in accounts receivable and/or an increase in inventory. Short-term financing is often used in seasonal businesses, where there is a seasonal spike in sales resulting in an increase in inventory and accounts receivable. For example, let’s think of a toy manufacturer. Toy stores have most of their sales around Christmas, forcing the toy store to increase inventory before Christmas. In anticipation of the Christmas season, the toy manufacturer makes toys in September – November, increasing its stock. The toy store buys toys from our toy manufacturer on credit, increasing the toy manufacturer’s sales and accounts receivable. The toy store will probably pay the toy manufacturer in January, after the Christmas season is over. The toy manufacturer must fund this seasonal difference between making goods and receiving cash. Short-term financing is then necessary.
Long Term Financing
Long-term financing, with a maturity of more than 12 months, is usually used for fixed assets. The most common use is to buy fixed assets. If a company purchases new equipment that will be used over multiple business cycles, long-term financing is needed. Ideally, the financing has a term that is equal to the useful life of the purchased equipment. A company would not want a short-term loan to purchase new equipment because it would be putting in a large amount of money that could severely hamper cash flow. If a small business bought a $100,000 piece of equipment with short-term financing at the beginning of the year, it would probably run out of money before the end of the year and would have to limit growth or borrow more money. If they had obtained long-term financing to purchase the equipment,
It’s important to know what kind of financing your business needs to maintain a healthy business. If a company uses a short-term loan to purchase a fixed asset, they could face cash flow problems in the future because they used the wrong type of financing. It is important to match the asset type with the right form of financing.
Brian Davis is a credit analyst based in High Point, NC. He has a bachelor’s degree in economics. He is also currently enrolled in the Master’s Degree in Entrepreneurship Program at Western Carolina University . Webmasters and other publishers of articles are hereby granted permission to reproduce articles as long as this article in its entirety, the author information and any links remain intact. Copyright 2011 by Brian Davis.