When Is It Appropriate to Use Short-Term as Opposed to Long-Term

If you operate a small business or are considering going into business for yourself, you will almost certainly want finance so your company may expand. It is essential to have a solid understanding of the two distinct forms of funding that are accessible, as well as the circumstances in which each should be used. Short-term and long-term funding are the two primary categories of this resource.

Financing on a Short-Term Basis

Short-term financing, or financing with maturities due in less than a year, is used to finance current assets. The most probable purpose for this kind of finance would be to support an increase in accounts receivable and an increase in inventory. Short-term financing is standard in seasonal firms, which see a surge in sales at certain times of the year, leading to a rise in inventory and accounts receivable at the end of the season. Take, as an example, a company that manufactures toys. Toy shops see the most of their annual revenue during the holiday season; as a direct consequence, they need to boost their inventory well before the holiday. To have a larger supply of toys available for sale during the holiday season, the toy producer starts producing new toys in September and continues until November. Toys are purchased on credit from our toy maker by the toy shop, resulting in increased sales for the toy manufacturer and increased accounts receivable. After the holiday shopping season, the toy retailer usually sends payment to the toy producer in January. This seasonal time discrepancy between producing items and getting revenue presents a challenge for the toy producer, who has to find a way to fund it. When this happens, finance on a short-term basis is required.

Financing on a Prolonged Timescale

Non-current assets are the most common recipients of long-term financing, defined as having maturities due in more than a year. The acquisition of fixed assets is by far the most typical use. Long-term financing is required whenever an organisation plans to invest in new equipment that will be used across several different operational cycles. In an ideal scenario, the financing will have a term that is equivalent in length to the equipment’s expected useful life. If a corporation wanted to buy new machinery, it would not want to take out a short-term loan since it would require them to make a significant financial commitment that may seriously hinder its cash flow. If a small firm spent $100,000 on a piece of equipment at the beginning of the year and financed the purchase with a short-term loan, the company would likely run out of cash before the end of the year and be forced to either curb their rate of expansion or borrow further funds. If they had gotten long-term financing to buy the equipment, the firm would not have been obligated to repay the one hundred thousand dollars in twelve months or less, and they would have probably been able to avoid cash flow concerns.

It is essential to have a solid understanding of the kind of funding your company needs to ensure its continued success. It is possible that a firm would run into cash flow issues in the future if they utilise a short-term loan to acquire a fixed asset. This is because they chose the incorrect sort of financing. Pairing the different kinds of assets with the appropriate kinds of funding is essential.