Choosing between long term and short term loans

Choosing between long term and short term loans

Business finance is a very important concept for all businesses – big or small. A business needs financing for establishing itself and also for its day-to-day operations. That is why every business manager needs to deal with the balance between long-term business finance and short-term business finance. This balance depends on a lot of factors and a mere whimsical decision is sure to result in business losses- a fate which every business manager wants to avoid. So, how does one achieve balance?

There are factors and considerations which help in choosing the right source of finance – long term and short term. Before understanding such factors, here’s a brief lowdown on the different sources of finance for the business:

Long term finance

As the name suggests, long term finance is the source of finance which entails loans for a longer tenure ranging from 3 years to as high as 20 years.

Sources of Long Term Finance

  • Equity Capital
  • Long Term Debt – bonds and debentures
  • Retained earnings of the business
  • Bank Loans, etc.

Short Term Finance

Short term working capital finance on the other hand deals in financing options which are chosen to finance the short-term working capital requirement of a business. These loans are repaid within a shorter tenure, which is a maximum of 3 years.

Sources of Short-term Finance

  • Bank Loans
  • Line of credit
  • Overdrafts
  • Repurchase Agreements, etc.

Which is better – long-term or short-term finance?

This is a relative question. The better of the two can be decided based on the usage or requirement of the business applying for the loan. If the business needs expansion or if business equipment is to be bought, a long-term loan makes more sense. However, if the business needs sufficient working-capital funding or needs to meet a surge in the demand, a short-term loan is more appropriate. How does one choose between short-term finance and long term finance?

Question – Do you need to expand your business permanently?

Business expansion requires a huge sum of money for buying the required equipment, hiring additional man-power, newer business premises, etc. All these additions necessitate funding. If a newer product line is to be introduced, necessary raw materials are also required to be sourced. If your business is into large-scale production, a longer term loan makes more sense while if your business is small or medium scaled, a small-term loan would be sufficient. So, the answer would be:

Answer – For business expansion, the source of finance would depend on the scale of business. Large scale business should opt for long term finance and small and medium scale business should opt for short term finance.

Question – What is the quantum of loan sought?

First assess the amount of loan needed. A larger amount of loan (above Rs.1 crore) might not be available as short-term finance. For such huge quantum of loans, a long-term source of finance would be your only choice. However, if the desired amount is in the lower ranges (within Rs.1 crore) short term finance options can be explored.

Answer – Short-term loans are better for lower loan amounts and long-term finance is apt for higher amounts.

Question – Is the repayment tenure and amount affordable?

Short term loans should be repaid back within 3-5 years. As such, the loan repayment instalment is higher. Long-term loans are repayable over a longer tenure and thus have lower instalments.

Answer – If your business can afford higher repayment instalments, a short-term finance is better.

Question – Do you have assets to back a long-term loan?

Long-term loans are granted only after a detailed scrutiny of the business and if the business is found to be profitable and viable. All long-term loans are secured loans which require a security to be pledged against the value of the loan. If a higher amount of loan is taken, assets of equivalent value need to be pledged. Short-term finance is an unsecured source of finance which does not require any security. As such, they are easier to obtain than long-term ones.

Answer – Long-term loans can be availed only by securing assets. If you don’t have collateral or don’t want to pledge your assets to secure a loan, short-term finance is the optimum choice.

Question – Are you ready to share ownership of your business?

Long-term equity capital can be sourced only by sharing the ownership of business. Venture capitalists also invest long-term capital when they are promised a stake in the business. A short-term loan, on the other hand, does not require the ownership to be shared with the lender or investor.

Answer – Long term equity finance would include sharing of ownership of business – a factor which should be kept in mind when opting for the same.

What is the final verdict?

As mentioned earlier, the verdict is a relative one. The choice of long-term financing over a short-term financing depends on the requirement. If the business requires a large source of funding with an affordable repayment option, long-term financing is better. Similarly, if the requirement is for a shorter duration where the loan sought is not very high, a short-term financing solution is better. A small business loan in India scores better over long-term ones because it is:

  • Unsecured
  • Relatively easy to procure
  • Quicker in making the funds available
  • Available with minimal documentation
  • Cheaper in terms of aggregate interest payouts.

However, if the requirement is on the higher side where funds would be required for a longer tenure, a long-term finance option is better.


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