Debt Financing: Long-term and Short-term debt

deniFrom our previous article on using debt to finance business growth, we concluded with the rule of thumb in debt financing: Never use short-term debt to finance long-term capital investments. The reverse is true.

Short-term debt is simply your financial obligations that are due between zero days to the next 12 months. The items falling under this category include bank overdrafts, short-term loans, accounts payables and part of the long-term debt that is due within the year.

Long-term debt on the other hand is debt that is due after 12 months and hence you have more time to raise the funds to repay it. More often than not the long-term debt is used to finance business expansion and growth. It can also be used to finance a start-up where raising equity capital is undesirable or not viable. In essence, any loan for a business that matures in more than 12 months is a long-term debt. However, the part of that long-term debt that is due within the year will be classified as short-term debt.

Never use short-term debt to finance long-term capital needs! Just why is this so?

Short-term debt usually attracts higher interest rates due to the short debt period. The money is also supposed to be paid back within a specified short period of time. When you invest the short-term loan in a long-term project, your money is tied up for the long-run and you shall not be able to meet your immediate financial obligations. This may result to a tainted credit rating for your business and yourself as an individual, if bankruptcy does not eventually ensue!

On the other hand, using long-term debt to finance short-term projects is not good financial practice either. The returns from the short-term project will come after the project is completed. Thereafter for the credit period of your long-term debt you shall be repaying both the principle amount and interest on money whose use and returns ended ages ago. It does not make economic sense to continue paying interest on money that is not currently generating returns!

To sum it up, financial prudence dictates that you match your short-term capital needs with short-term debt while the long-term capital investments should be financed by long-term debt. That way you are safe in your investment provided our rate of return from the investment exceeds the interest rate for the debt.

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