The Difference Between Long Term And Short Term Loan: We all know the basic thing that to run a company funds are needed, but do you know how companies raise the funds to meet their capital requirements? If not, then let us try to know about it.
Any listed company generally uses two major sources to raise capital and they are owned funds (Share Capital) and Borrowed funds (Debentures).
When it comes to own funds, they are the shares issued by the company to the public to raise capital. They are called owned funds as the equity shareholders are also the owners of the company and have voting rights in the company.
But when it comes to borrowed funds, it is mostly the debentures, which is the debt fund borrowed by the company. Here it is called borrowed funds as debenture holders are the lenders to the company and do not have voting rights.
In this blog, let us dig deeper into the topic related to the difference between long term and Short term loans and try to know more about it, keep reading!
What Is Loan / Borrowing?
Borrowing refers to raising money from external sources for which interest needs to be paid to the lenders and the rate of interest paid itself is the cost of borrowed capital. In simple terms, it is the debt capital of the company.
A company cannot borrow money randomly unless it is authorized to do so in its MOA (Memorandum Of Association). Under section 179 of the Companies Act, 2013, only the Board Of Directors of the company can pass a resolution to borrow the money in the form of debentures, and such money is called debt funds.
Now that we have understood the meaning of borrowing, let us see what are the types of borrowings. A company cannot borrow in the same way for all its needs. Therefore, a company has categorized its borrowings pattern based on the requirements of funds and the company’s repayment capacity. Let us see them one by one.
Also Read: How to Get a Loan Against Shares – Requirements, Eligibility & More!
Types Of Loans
The borrowings are broadly classified into two types:
1. Short Term Loan:
The borrowed funds that a company needs to repay within a year or within the company’s current accounting year is termed short-term debt taken by the company. The short-term borrowings are shown under the section of current liabilities on the liabilities side of the balance sheet. Some examples of short-term borrowings include accounts payable and short-term loans.
2. Long Term Loan:
The debts that a company can repay after a year or more (which is generally long-term) are called long-term borrowings. The long-term borrowings are shown under the head of non-current liabilities in the balance sheet. Some examples of Long term borrowing are long-term bonds, bank loans, debentures, mortgages, etc.
Now that we have understood the meaning of Long term and Short term loans, let us quickly see the key differences between them.
Sl no | Basis | Short Term Loan | Long Term Loan |
1 | Repayment period | Generally within one year | Generally more than one year |
2 | Purpose of borrowings Funds | Short term Loan, in general, are taken to meet the operating expenses that a company has to incur to run the daily activities like paying miscellaneous expenses, stationeries, inventory costs, travelling expenses, etc. | Long term Loan, in general, are taken to meet the major long-term needs of the business such as the acquisition of assets, and expansion of the company. |
3 | Category | It is classified as a current liability in the balance sheet of the company. | It is classified as Non- Current liability in the balance sheet of the company. |
4 | Cost of Funds | Short-term debt is more costly because in the short term any sudden change in economical status can make a huge impact on interest rates. | The long-term debt interest rates are lesser because small fluctuations in the economy will not have much effect in the long run |
5 | Examples | Accounts payables, Short term loans, commercial papers, lease payments, bank overdraft | Credit lines, bank loans, Debentures, and bonds are the examples of long-term borrowings |
6 | Suitability | Labour-intensive companies like manufacturing industries may require a lot of cash in business on a daily basis to pay wages to workers. Such companies can opt for Short term borrowing. | Capital-intensive companies like technology based companies may need a huge volume of capital at once. Such companies can opt for Long term borrowing. |
7 | Liquidity | Short-term debts are highly liquid in nature and can be converted to cash easily | Long-term debts have less liquidity compared to short-term debts and may take some time to convert them to cash. |
How Do Companies Choose The Type of Debt?
The answer to this question is highly subjective and is dependent on several factors like the nature, size, and type of the company. If a company wants to make big expansions and needs huge money for a long tenure, it can go for Long term borrowings. On the contrary, if the company is in need of money for operational activities and money can be returned within a short time these companies may go for short-term borrowings.
The borrowing decision thus solely depends on the requirement of the company at that particular time. But to maintain a stable capital structure the company should have a balanced combination of both short-term and long-term debt funds.
Also Read: What Do You Mean By Debt And Equity Market?
Closing Thoughts
In this blog, we have discussed in detail about Loan funds/Debt funds. Further, we learned about What are long term and short term Loans, what are the key differences between Long term and Short term loans, and how can a company use them to build a proper capital structure along with examples.
As both types of funds have different characteristics the company should mindfully choose the type of debt that suits them well to avoid the unnecessary costs of finance. That’s for this blog, Happy reading!
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