When is short-term and long-term financing accordingly?
As a small business owner or entrepreneur who aspires high, you may need to finance to help your business grow. It is important to understand two types of financing available and when each accordingly. The two types of main financing are short-term and long-term financing.
Short-term financing, maturity due in 12 months or less, is used to fund current assets. This type of financing is likely to be used to fund increased receivables and / or increased inventory. Short-term financing is often used in seasonal businesses, where there is a surge in seasonal sales, resulting in increased inventory and receivables. For example, let’s think of a toy manufacturer. Toy stores experience most of their sales around Christmas, as a result of a toy store need to increase inventory before Christmas. To anticipate the Christmas season, toy manufacturers create toys in September – November, improve their inventory. Toy stores buy toys from our toy manufacturers with credit, increase sales and receivables toy manufacturers. Toy stores may pay toy manufacturers in January, after the Christmas season ends. The toy manufacturer needs to finance this seasonal time difference between creating goods and receiving cash. This is when short-term financing is needed.
Long-term financing, maturity due in more than 12 months, mostly used for non-smooth assets. The most common use is to buy fixed assets. If a company buys new equipment to be used for several operating cycles, long-term financing is needed. Ideally financing will have the same term as the useful life of the equipment purchased. The company will not want a short-term loan to buy new equipment because they will do a lot of funds that can inhibit cash flow. If a small company buys $ 100,000 with short-term financing at the beginning of the year, they are likely to run out of money before the end of the year and must limit growth or borrow more money. If they will get long-term financing to buy equipment, the company will not be committed to paying back $ 100,000 in 12 months or less and the possibility of avoiding cash flow problems.
It is important to know what type of financing is needed by your business to maintain a healthy company. If a company uses short-term loans to buy fixed assets, they may experience cash flow problems in the future because they use the wrong type of financing. It is important to match the type of asset with the correct type of financing.