Debt can be described as borrowing money from outside with the obligation to return the principal amount along with the prescribed rate of interest. There are some common types of debts such as Bank loans, credit cards, mortgages, and overdrafts. Debt financing can be categorized into: 1) Short-term financing and 2) Long-term financing.
Short-term financing connotes to any form of finances which obligates the borrower to return the principal amount along with the interest rate within a year or maximum two years. The most basic use of this kind of financing is to handle day to day operations or to manage working capital. In short-term financing, there are normally 4 types of options available for borrowers. These are as following:
- Overdraft: Overdraft acts as an instant extension of the credit limit from the lending institution. In the overdraft arrangement, a company can extend the credit and transmit cash beyond its prescribed limit. Interestingly, it doesn’t limit the capacity of the company to pay back within a fixed period of time. The amount of credit given to the borrower is decided by the loan arrangement with the bank.
- Short-term loan: It is the loan arrangement which needs to be repaid within a year or two along with specific amount of interest. The difference between an overdraft and short-term loan is that overdraft revolves in nature and doesn’t have a fixed repayment period, however in the case of short-term loan, it has a fixed repayment period.
- Letter of Credit: Letter of credit comes under the umbrella of short-term financing which is in the form of a letter from the bank which guarantees the buyer’s payment to the seller. It ensures the seller that he will receive an amount within a given period. The best benefit of such an arrangement with the bank is that it provides leverage to the companies to negotiate better credit terms with the suppliers.
The risks involved in the short-term financing is the over reliance of the company towards credit lines. Company may take more business risks by offering aggressive credit terms to the customers. Another risk is that badly maintained credit lines will result in the poor credibility of the company which may blacklist the company among credit bureaus.
On contrary to short-term debt financing, long-term debt financing is primarily for long term business investments that usually have longer pay-back periods. Such kind of financing is made for e.g. buying of machinery and the machinery will be instrumental in producing goods within 5 year time period. Usually, there are two types of long-term financing opportunities available:
- Leasing: The benefits of leasing for a company is to use an asset without even having paid a full amount upfront. The agreement of a lease basically allows lessee to pay a fixed rental payments in order to utilize a capital asset. It is basically a rental agreement between the leasing company and a lessee. However, there is a clause in it which allows lessee to buy or own the machine at a reduced rate at the end of the rental agreement.
- Term loan: A term loan is the loan agreement between a company and a bank in which company needs to repay the amount back with more than a one-year period. It is usually secured by the companies who plan to have long-term investments or longer repayment horizons. Term loan is usually taken by the companies to acquire a new factory, machinery or production equipment. This term loan is usually repaid in periodic installments. Mortgage is one of the forms of long-term loan. It is usually secured by the collateral of some real estate property. This kind of a loan is usually amortized and the borrower comes under the obligation to repay the loan amount through periodic payments. Failing to do so will give a right to the lender to possess the mortgaged property.
This is to keep in mind that long-term financing is a riskier one as a large amount of capital is involved in such kind of debt financing. Also, in case of breach of the debt contract, companies may have to face serious consequences like loan amount to be repaid in full or mortgage asset will be confiscated immediately.