As a small business owner or an aspiring entrepreneur, you will likely need financing to help your business grow. It is important to understand the two different types of financing available and when each is appropriate. The two main types of financing are short-term and long-term financing.
Short-term financing, maturities due in 12 months or less, is used to fund current assets. This type of financing would most likely be used to fund an increase in accounts receivable and/or an increase in inventory. Short-term financing is frequently used in seasonal businesses, during which there is a seasonal sales spike, resulting in an increase in inventory and accounts receivable. For example, let’s think of a toy manufacturer. Toy stores experience most of their sales around Christmas, as result the toy store would need to increase inventory before Christmas. In anticipation of the Christmas season, the toy manufacturer creates toys in September – November, increasing their inventory. The toy store purchases toys from our toy manufacturer on credit, increasing the toy manufacturer’s sales and accounts receivable. The toy store likely pays the toy manufacturer in January, after the Christmas season is over. The toy manufacturer needs to finance this seasonal timing difference between creating goods and receiving cash. This is when short-term financing is necessary.
Long-term financing, maturities due in more than 12 months, is mostly used for non-current assets. The most common use is to purchase fixed assets. If a company is purchasing new equipment that will be used over several operating cycles, long-term financing is needed. Ideally the financing will have a term equal to the useful life of the equipment being purchased. A company would not want a short-term loan to purchase new equipment because they would be committing a large amount of funds that could severely hamper cash flow. If a small company purchased a $100,000 piece of equipment with short-term financing at the beginning of the year, they would likely run out of cash before the end of the year and have to limit growth or borrow more money. If they would have obtained long-term financing to purchase the equipment, the company would not be committed to paying back the $100,000 in 12 months or less and likely have avoided cash flow problems.
It is important to know what type of financing your business needs in order to maintain a healthy company. If a company uses a short-term loan to purchase a fixed asset, they may experience cash flow problems in the future because they used the wrong type of financing. It is important to match the asset type with the correct financing type.