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Friday, November 8, 2013

Advantages and Disadvantages of Short-Term Financing



The three possible financing policies described above were distinguished by the relative amounts of short-term debt used under each policy. The aggressive policy called for the greatest use of short-term debt, while the conservative policy called for the least. Maturity matching fell in between. Although short-term credit is generally riskier than long-term credit, using short-term funds does have some significant advantages. The pros and cons of short-term financing are considered in this section.

Speed

A short-term loan can be obtained much faster than long-term credit. lenders will insist on a more thorough financial examination before extending long-term credit and the loan agreement will have to be spelled out in considerable detail because a lot can happen during the life of a 10 to 20 year loan. Therefore if funds are needed in a hurry the firm should look to the short-term markets.

Flexibility

If its needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for three reasons: (1) Flotation costs are higher for long-term debt than for short-term credit. (2) Although long-term debt can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a firm thinks its need for funds will diminish in the near future, it should choose short-term debt. (3) Long-term loan agreements always contain provisions, or covenants, which constrain the firm’s future actions. Short-term credit agreements are generally less restrictive.

Cost of Long-Term Versus Short-Term Debt

The yield curve is normally upward sloping, indicating that interest rates are generally lower on short-term debt. Thus, under normal conditions, interest costs at the time the funds are obtained will be lower if the firm borrows on a short-term rather than a long-term basis.

Risks of Long-Term Versus Short-Term Debt

Even though short-term rates are often lower than long-term rates, short-term credit is riskier for two reasons: (1) If a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense will fluctuate widely, at times going quite high. For example, the rate banks charge large corporations for short-term debt more than tripled over a two-year period in the 1980s, rising from 6.25 to 21 percent. Many firms that had borrowed heavily on a short-term basis simply could not meet their rising interest costs and as a result, bankruptcies hit record levels during that period. (2) If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt. If the borrower is in a weak financial position, the lender may not extend the loan, which could force the firm into bankruptcy. Braniff Airlines, which failed during a credit crunch in the 1980s, is an example. Another good example of the riskiness of short-term debt is provided by Transamerica Corporation, a major financial services company. Transamerica’s chairman, Mr. Beckett, described how his company was moving to reduce its dependency on short-term loans whose costs vary with short-term interest rates. According to Beckett, Transamerica had reduced its variable-rate (short-term) loans by about $450 million over a two-year period. We aren’t going to go through the enormous increase in debt expense again that had such a serious impact on earnings, he said. The company’s earnings fell sharply because money rates rose to record highs. We were almost entirely in variable rate debt, he said, but currently about 65 percent is fixed rate and 35 percent variable, We’ve come a long way, and we’ll keep plugging away at it. Transamerica’s earnings were badly depressed by the increase in short-term rates, but other companies were even less fortunate they simply could not pay the rising interest charges and this forced them into bankruptcy.

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