Financing: Long Term and Short Term - Essay Example

? Financing: Long-term and Short-term Heather Jenks Corporate Managerial Finance BUS 657 John Brock Date of Submission: Introduction Any form of investment or business need to acquire finance that they will use in one way or the other in order to get established. Finance makes one of the fundamental requirements for establishment and good running of a business. Finance, however, may be acquired through different methods depending on its availability and the ease of repaying it. Financing means the provision of financial materials that a business requires. There are two major categories of financing that normally exist in most businesses (Jim, 2011). These categories are short term and long term financing methods. These categories basically differ in the period for which they are provided to the business. For instance, short term financing is a type of financing that is provided for a short period of time, usually not exceeding one year, to the business. On the other hand, long term financing is any type of finance source for a business that is provided for a long period of time, usually exceeding one year, to the business. This paper aims at discussing the two categories of financing, their applications, examples, current trends and real experiences with the two categories of financing. Short-term Financing This is the type of financing for a business that is normally required for a short period of time, usually less than one year (Pagirl, 2009). It is normally required by the business in order to provide the working capital for the business. The working capital is the capital that is used by the business to purchase raw materials required by the business on a daily basis, payment of salaries and wages, and to meet the day to day expenses of the business (KreditnaBanka, 2012). For example, a company like Nestle may require performing a number of activities in the coming months. They may decide to promote their new product in the market. To do this, the company may decide to contract sales and marketing personnel just for the promotional period, it may need to organize a road show, media advertisement and other events. The company however will need finance to carry out these activities. The kind of finance that the company needs is referred to as short term financing. This is because the finance is needed for a short period of time just to meet certain obligations of the business. From the example, therefore, short term financing may also be required in order to meet seasonal finance requirements of a business. This finance is normally available at lower rates of interest. This short term financing for a business, however, must come from some source. Some sources of short term finance include; trade credit, advances from customers, financial institutions and commercial banks among others. Application of Short term financing Firms may need short term financing in order to fill the balance left by the insufficient cash flows of the business to meet the short term financial needs of the business (Gregory, 2004). Therefore, short term financing is applied when the cash flows of the business are not sufficient to meet the financial demands of the business in a short period. Some firms may need to acquire inventory now or meet other short term asset needs now rather than wait for so long for the business to make enough money, in this case, short term finance is necessary and applied. Types/examples/sources of short term financing a) Short term loans These are loans given by commercial banks or financial institutions to businesses in order to meet their short term financial obligations. These loans are given for a period of less than one year. These loans include promissory notes and a line of credit. b) Trade credits These are short term finances given to businesses by their suppliers. It is a form of act of businesses delaying their payments to the suppliers for a period of 30 days. This method may have a cost in the form of some interest that is charged by the suppliers on the unpaid balance. Sometime, the cost of trade credits may be the lost discount given to firms that pay earlier. Since credit has a cost, this cost may be felt by the customer by paying high prices or the business getting low profits. c) Commercial papers These are short period finances given to larger business entities with a large credit worth. This is quoted on a discount basis. It is where the interest is subtracted from the face value to remain with the price (Gallangher & Andrew, 2011). Strengths of Short term Financing The major strengths of this type of financing are that it is easily available, therefore it is easily accessible. Being that it is for short term obligations, it is not normally a very large amount hence it can easily be found from several financial institutions and commercial banks. Short term financing also has a lower cost since it is paid back after a short period of time. The interest charged for the finance in normally small hence its lower cost. In addition, short term finance also meets the short term need for assets and inventories at a time when such needs are necessary. Weaknesses of short term financing Short term financing involves the business into the payment of interests that could otherwise become its profits. It is not a type of finance that can sustain the business for a longer time, like more than one year. Short term financing also may make a business assume the ownership of inventory or assets, yet in a real sense, these are properties on credit that one must payback for. Real experience My dad owns a small hardware where he sells various building and construction materials. Last year when he fell sick for a period of one month, most of the funds from the business were used to take him to the hospital. When the business resumed, there was less stock and the money to take new stock was also not available. For the business to get back to its normal operation, my dad had to borrow some short term loan from the bank, to restock the hardware, which he paid back within 8 months. The loan was given at a cost of 10% per year. He also had an agreement with some of his previous suppliers to just supply him with the inventory on credit, which he was intending to pay back later as soon as he got the money, but before the end of the first month. My dad’s hardware got back into form, thanks to short term financing methods that he applied. Long Term Financing This is a kind of financing that is provided for a business for a long period, usually more than one year (Alex, 1997). All business entities of any kind need long time financial services, irrespective of their sizes or statue. Different business entities use long term financing differently. Other business entities, which are not large corporations, can only use long term financing for the purpose of debt. Corporations on the other hand can do use the long term financing for both debt and equity financing. Still using the example of Nestle Company, the company may need to carry out a long term change in the company structure or get into another permanent or long term investment. The company may need to get into a program of expanding its area of coverage by opening several branches in various other countries all over the world. In such cases where large sums of financing are required, and the need for the financing is also a long term project, the company normally creates ways of obtaining such finances. Some of the most common sources of long term financing are together with equity, debt as well as derivatives. Applications of long term financing Long term financing is normally required for projects such as modernization, expansion, diversification; where huge quantities of materials and funds are required as well as in irreversible decisions of a business (Vyuptakesh, 2000). Long term financing is also necessary in situations of the assets do not match the liability, where there is an interest rate risk as well as liquidity risk. They also become fundamental when the financial requirements of a business cannot be met by short term financing. Sources/Types/Examples of Long term Financing a) Equity capital This is described as an authorized, issued, subscribed and paid up capital. Equity capital exists in a par/face value, book value and market value. Equity shareholders are entitled to certain rights which include rights to income, rights to control, pre-emptive right as well as rights in liquidation. The pros of equity capital include the fact that it does not have fixed maturity, no obligation to redeem, no compulsion to pay dividends, it provides leverage capacity and dividend tax are exempted for investors. Some of the cons include high cost of rate of return, issues costs are high, higher servicing costs as well as dividends being non tax deductible. b) Preferred Capital This is a hybrid form of financing that has both equity and debt features. For instance, by being out of the distributable profits, having no obligatory payments and its dividends being non tax deductible are an equity feature of preference capital. Having dividend rates fixed its capital unredeemable and shareholders having no right to vote are debt characteristics of preference capital. These have pros like no obligation to pay dividends, no dilution control; it is part of the business net worth hence it increases its credit worthiness and no pledging of assets is required. The cons on the other side include, it is an expensive source of financing since dividends are not tax deductible, though there are no legal consequences, the liability to pay dividends still remain hence this can spoil the image of the company. This source can acquire voting rights in some cases and it also has a claim prior to equity holders. c) Term Loans This is a source of business financing that is provided by financial institutions and banks. This source can receive funding either in foreign or domestic currency. These sources are typically secured against fixed assets or hypothecation of movable properties, prime security or collateral security. This source of long term financing has definite obligations on principal and interest repayment. The interest in this case is paid periodically based on the rate of the credit and it is pegged to the floor rate. This is the source that carries restrictive covenants concerning future financial and operational decisions of the company, its management, company projects, future fund raising as well as the company’s periodic reports called for. The pros of this source include the fact that interest on debt is tax deductible, the method does not result in dilution of control, it does not take part in the value created by the firm, the issue cost of debt is lower, the interest cost is normally fixed and this offers protection against unexpected inflation as well as having a disciplining effect on management. On the other hand, the cons for this source include the fact that it entails fixed obligation for interest and principal therefore, non-payment can lead to bankruptcy or legal action, debt contrasts of this source impose restrictions on the firm’s financial as well as operational flexibility, it increases financial leverage and excess of this would raise the cost of equity to the firm and when the inflation rate dips, the cost of debt would be higher than expected. d) Debentures These are instruments used to raise long term credit debts just like promissory notes. These instruments are more flexible as compared to term loans since they offer a variety of choices as far as choices, interest rate, security, repayment and other special features are concerned. The interest rates as regards to debentures can be fixed, floating or deep discount. They can have attached warrants, detached, detachable or non detachable warrants. Its bullet payments are redeemed in installments and it can either be secured or unsecured. With this instrument, there is a need to have a credit rating through a credit rating company. Other forms of long term financing include leasing, hire-purchase, securitization, government subsidies, sales tax deferment, and exemptions and suppliers' credit. Among these, hire-purchase and leasing normally confuse people. In leasing, there is no transfer of ownership while in hire-purchase, ownership is transferred. In leasing, the lessor receives depreciation benefits while on hire-purchase there is only a depreciation shield to hire. There is a magnitude of funds in big ticket items in leasing, while in hire-purchase, maybe for smaller value capital goods. The laser is expected to maintain the item under lease by themselves, while in hire-purchase; the maintenance cost is borne by the hirer. In leasing, there is no margin money, also known as down payment, required, while on hire-purchase, there is some down payment that is required. There is tax benefit depreciation in leasing, taken by the leaser, while the lessee gets tax shield on lease rentals; on hire-purchase, the hirer is allowed the depreciation claims and finance charged for taxation; while the seller may claim interest on the amount they borrowed in order to acquire an asset. Leasing is a method that is considered to be off balance sheet mode of financing; this is because there are no asset or liability costs of leasing in the balance sheet, while in hire-purchase, the asset figures are recorded on the balance sheet at the completion of the purchase. Long term finance is normally raised through various processes such as an initial public offer (IPO), bought out deals, private placement, preferential allotment, right issue, secondary public offer, venture capital among other processes. Current trends in long term financing Currently, several companies have been seen to be fond of raising funds through initial public offers (IPOs) (Roger, 2008). This normally works well for them since at this time, the floor is opened for everyone and one may purchase shares at a certain offer. This draws many buyers from all over, plus those who could have not been able to make purchases after the IPO is closed, or during the secondary public offer. Conclusion Financing is very fundamental to businesses. There are two broad categories of financing; short term financing and long term financing. A firm chooses a particular category of financing depending on its financial requirements. Short term financing is required for liquidity purposes while long term financing is required for expansion, diversion and permanent financing options of a firm. There exist various ways under each broad category, through which a business can be financed, therefore, a manager needs to be careful while choosing the option that best fits its firm’s financial requirement. This research has managed to find out several sources of financing, their pros and cons as well as their applications, and real experiences of entrepreneurs with the sources. References Alex, T. (1997). Long Term Financing. Morevalue.com , 2-6. Gallangher, & Andrew. (2011). Short-term Financing. 1-10. Gregory, A. K. (2004). Fundamentals of Financial Management. Pearson Education Limited , 1 42. Jim, F. (2011). Difference Between Long-Term & Short-Term Financing. eHow Journal , 1-4. KreditnaBanka, Z. (2012). Short-term and Long-Term Financing. Corporate Banking . Pagirl. (2009). Long-term and Short-Term Financing Week 5 Day 5. StydyMode.com , 1-2. Roger, L. (2008). When Genius Failed: The Rise and Fall of Long-Term Capital Management (Vol. VI). England: Random House. Vyuptakesh, S. (2000). Fundamentals of Financial Management (Vol. III). Pearson. Read More