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What are the differences between short-term and long-term finance functions or decisions?
Although both functions are related to finance,there are some distinctive differences between long and short-term financing decisions. Long-term decisions are made for more than a year while short-term decisions are yearly decisions. It is easier to understand when we compare some of the long and short-term decision examples.
Note − There are differences between long-term and short-term financial decisions.
Long-term decisions often offer the strategy of the businesses. Some types of long term decisions include the following
Capital Budgeting is an investment decision where long-term budgets are prepared by companies. There are mainly two considerations in capital budgeting −
Evaluating the probable profitability or rate of return from the capital invested.
The cut-off rate by which the returns of the investment can be compared with an expected rate of return.
It is hard to measure the future rate of returns and hence long-term budgets have some risks associated with them. Investors look for past performance and past rates of returns to make investment decisions in long-term entities.
Apart from investment shifts for better returns, capital budgeting also requires replacement decisions which are decisions to recommitting funds when the investment gets weaker or non-profitable.
The cut-off rate is the opportunity cost in capital budgeting measures. It is the expected rate of return that an investor can derive by investing in a long-term investment.
Note − Capital Budgeting is a good example of a long-term investment decision.
In investments, the fund managers often choose a mix of debt and equity for better and risk-free results. It is known as capital structure. The financial manager's role is to obtain the best capital structure for better returns. A firm's capital structure is optimum when the market value of its shares is maximum.
The use of debt increases returns but it is very risky as well. The change in shareholder's capital due to a change in debts is known as financial leverage. When shareholders' return is maximized keeping the risks intact, the capital structure is termed optimum.
The dividend payout ratio determines the payout of dividends divided by total dividends and it is a major decision of companies. The companies usually follow an optimum dividend ratio so that the balance between profit distribution and reserves remains intact. In this function, bonus shares may be offered to shareholders for free.
Note − Bonus shares are offered to shareholders for free under the optimum dividend payout policy.
Short Term Decisions
The short-term decisions involve day-to-day decisions and are often of tenure of one year. The major decision taken in the short-term mode is the liquidity decision.
Liquidity Decision − Current assets affect companies in managing the liquidity and hence are important in nature. Lack of liquidity may result in insolvency. There is always a trade-off between profitability and liquidity. So, the managers must take the probability-liquidity trade-off seriously. This decision is important to make sound financial outcomes too.
An investment manager must know how to deal with short-term and long-term decisions for a good financial performance of the firm. Once there is a balance between long and short-term decisions, the profitability of the company increases automatically.
Note − A balance between short-term and long-term goals is necessary for maximum returns on investment.
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