Short-term financing versus long-term financing

Two factors influence the duration of external financing that businesses seek. The first – is availability. A firm may want to take out a ten-year loan to finance its inventory purchases, but may find no one willing to make such a loan. In general, businesses can usually find financing for short time periods. It is more difficult to find long-term financing. The second factor influencing the length of time that firms finance for is the return, or liquidity-profitability, trade off. Short-term financing is usually cheaper than long-term financing because short-term interest rates are normally lower than long-term interest rates. Therefore the desire for profitability (return) pushes firms toward short-term financing. Long-term financing is regarded as less risky than short-term financing because the borrower locks in the agreed-on interest rate for a long period of time. No matter how interest rates change during the life of the loan, the borrower's interest costs are certain. Furthermore, the borrower does not have to incur the transaction costs of obtaining new financing every few months. So, the desire to avoid risk encourages firms to use long-term financing. The length of time that firms finance for depends on whether they want “to eat well or to sleep well." Returns generally increase as financing maturities grow shorter, but so does risk. Risk decreases as financing maturities grow longer, but so do returns. The blend of financing maturities that a firm selects reflects how "aggressive" or "conservative" the firm's managers are.

Short-Term Financing Alternatives. When most businesses need money for a short time–that is, for less than one year– they usually turn to two sources: short-term loans and trade credit (the process of delaying payments to suppliers). Large, well-established businesses may make use of a third financing source: commercial paper. Here are various aspects of obtaining money from these three sources:

Short-Term Loans from Banks and Other Institutions. Financial institutions offer businesses many types of short-term loans. No matter what the type of loan, however, the cost to a borrower is usually measured by the percent interest rate charged by the lender. The annual interest rate that reflects the dollars of interest paid divided by the dollars borrowed is the effective interest rate. Often, the effective interest rate differs from the interest rate advertised by the bank, which is known as the stated interest rate.

Two common types of short-term loans are self-liquidating loan and the line of credit. No matter what type of loan a firm uses, the firm must sign a promissory note – the legal instrument that the borrower signs, which is the evidence of the lender’s claim on the borrower. Self- liquidating loan is one in which the proceeds of the loan are used to acquire assets that will generate enough cash to repay the loan. The line of credit is the borrowing limit a bank sets for a firm. The line of credit is an informal agreement. The bank may change a firm’s credit limit at any time as business conditions change.

Trade credit. When a company purchases materials, supplies, or services on credit instead of paying cash that frees up funds to be used elsewhere, just as if the funds had been borrowed from the bank. Trade credit is the act of obtaining funds by delaying payment to suppliers. The longer the company delays paying for purchases, the more trade credit the firm is said to be using.

Commercial paper. Firms can also sell – unsecured notes issued by large, very credit-worthy for up to 270 days – to obtain cash. Selling commercial paper is usually a cheaper alternative to getting a short-term loan from the bank. Only large, credit-worthy corporations can sell commercial paper because only they can attract investors who will lend them money for lower rates than banks charge for short-term loans.

Exercise 7. Read the text once again and find key words in every passage.

Exercise 8. Read every passage once again and express its contents in one sentence.

Exercise 9. Translate the sentences into English. Review grammar in §1, §2, §3, §4 of grammar supplementary:

1. Долгосрочное финансирование считается менее рискованным.

2. Предприятия используют различные источники финансирования, чтобы поддержать бизнес.

3. Вам следует понизить процентную ставку, чтобы привлечь заказчиков.

4. Известно, что он брал кредит, чтобы основать частную собственность.

5. Задача заключается в том, чтобы снизить риск потерь.

6. Мы бы хотели снизить кредитный лимит.

7. Я бы хотел, чтобы они рассказали об условиях краткосрочного кредитования.

8. Предполагается, что кредитная линия – это минимальное ограничение, которое банк устанавливает для предприятия.

9. Известно, что продавать и выпускать коммерческие бумаги может только большая и кредитоспособная корпорация.

10. Ему следует обсудить проблему с партнерами, чтобы сделать правильный выбор.

Exercise 10. Study the chart which shows External Financing Source-Selection Process and define what factors should a firm consider before selecting the short-term financing sources.