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Trade-off between Long-term and Short-term Financing
Businesses often need to decide whether they will go for short or long-term financing for running their businesses. The main aim of an organization is to offer maximum wealth to shareholders which is possible when a firm generates enough profits. However, the organizations must also keep an eye on the interest rates because the rates may sometimes be palpable to eat a significant chunk of earnings.
It has been generally observed that short-term financing is preferable to long-term funding. Short-term financing has the benefits of cost and flexibility that make it more attractive than long-term financing.
Following points will help you understand the concepts better −
Cost of Financing
It is generally observed that short-term financing is less costly than long-term financing. As there is a time factor attached to long-term financing and the loan is tied up for a longer tenure, the time to get the interest back takes time in the case of long-term funding. Therefore, lenders prefer to extend loans for short terms.
The interest rate on financing is related to the maturity of the debt. The curve obtained by putting maturity of debt against interest rate is generally upward sloping, showing that long-term interest rates tend to be higher in most cases.
Higher Interest Rates
The higher interest rates on long-term financing are also supported by the liquidity preference theory. This theory summarizes that most lenders would prefer short-term loans because the time attached to long-term loans is palpably longer which makes the risk-averse investors look for options to shove off risks that will arise if the loans are offered for long terms.
Cost of Lending
The cost of lending attached to loans has an effect on the returns. Loans usually have an effect on shareholders’ wealth. However, short-term loans that have a lower cost than long-term ones provide more returns to shareholders. That is why short-term loans are preferred by both firms and their shareholders.
Flexibility of Short Span of Time
It is generally observed that firms choose short-term financing due to their flexibility to get shortened within a short span of time. If the requirement of loans diminished within a short term, the short-term loans are preferable both for risk averse investors and the firms because none of the participants want to remain tied up with the obligation of a loan for a long tenure.
Borrowing Risk
Although short-term loans have the advantages of cost and flexibility, the inherent risks attached to them are higher than long term financing. Usually, a company needs to continually rely upon short-term financing to run its business. It has to borrow again and again to meet the needs of permanent current assets. This pushes the company to a risk of defaulting when the credit periods are tough.
Defaulting in paying loans makes the company unattractive to the lenders and the companies must pay higher interest to lenders if it still wants to keep borrowing to meet its short-term needs. Therefore, the companies must look for long-term financing if it has to fend off the risk of illiquidity in the short term.
Risk-Return Trade-off
Companies face a continuous trade-off between long-term and short-term financing. If it needs to avoid costs and gain flexibility, it should go for short-term financing. On the other hand, if it has to mitigate the risks, it must look for loans that are long-term.
The choice of financing depends upon the company. It is the structure of the business and its nature that must be considered while going for financing. Short-term financing is good if the costs have to be minimized and the interests need to be diminished within a short period of time while long term loans are less risky when it comes to realizing them.
Conclusion
The ultimate choice of financing is therefore dependent on the short and long-term trade-off of financing the businesses. And this choice of financing is therefore upon the company.
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