Short-Term Debt

A debt that can be repaid in a short period of time

A debt is an obligation of a person or company resulting from some transaction or event. Debts usually include loans, mortgages, financing, bonds, etc. 

Short-term debt

Generally speaking, commercial debts are bound by contracts signed between the creditor and the debtor concerning terms of principal, interest, and time. Debt can result from the state, local government, company, or individual actions.

This debt can be repaid in a short period of time. It usually lasts less than a year. It is generally found under current liabilities on a company's balance sheet.

This can include short-term loans from banks or private loan companies, usually repaid with principal and interest within a year. It also includes accounts payable that the company owes to its customers and commercial paper issued by a company.

Companies generally incur debt because of maintenance needs, business expansion, etc. 

The use of short-term financing advantages for many business operators is very obvious, such as enterprises can receive loans quickly, and the application process will not be too complicated.

This is very important for many businesses. Companies may be able to avoid the credit risk of default by getting a loan a day or two in advance. This type of loan can be a good way to help a company solve a very urgent cash flow problem.

At the same time, these short-term loans also bring some risks. For example, the interest rate of short-term loans is usually high, which may increase the difficulty for the debtor to repay. Whether a company needs to use short-term loans depends on different circumstances.

Short-term loan

Enterprises generally borrow short-term loans from banks or other institutions according to their operation or production needs. 

The term of the short-term loan is usually less than one year, and when the loan term expires, the company must repay the principal and interest. Short-term borrowings have lower interest rates than long-term borrowing. 

Debt

For companies, short-term borrowings are generally used for emergency operations. Enterprises may face cash flow constraints due to some unexpected problems. That's when companies borrow short-term to ease cash flow pressure. 

Or sometimes, enterprises need to borrow money due to some objective factors to increase the company's cash flow and expand production. In this case, the company may also choose to take out short-term loans to make the company have more sufficient cash reserves.

Before borrowing money, creditors and debtors will sign a loan contract. Different according to the contract's requirements, short-term loan repayment payments can be divided into pay by the month, pay by half a year, or one year after the expiration of principal and interest.

When signing a loan contract, due to the influence of the debtor's credit rating and the amount of borrowing, sometimes the lender may only need the debtor's credit as a guarantee.

But more often, the creditor needs the debtor to give some property as collateral, such as securities or real estate. 

Contract

This form of mortgage loan is relatively common. Creditors decide how much to borrow based on the value of the collateral and their risk appetite. Such collateral is secured to reduce uncertain losses in the future.

If the enterprise can not provide the collateral or the loan amount is far higher than the value of the collateral. Then, to reduce and transfer the risk, the creditor will require the debtor to find a third party as the guarantor to sign the loan contract together. 

When the debtor cannot repay due to uncertain factors, the guarantor shall continue to perform the debt per the original contract. Such an approach would make creditors more willing to lend to debtors and make more money available to debtors.

Accounts Payable

Accounts payable is a short-term debt incurred by a business that has received goods or services before payment is made. Accounts payable are shown under current liabilities on the balance sheet. There are many examples of accounts payable. 

For example, when Company A has received the raw materials provided by the supplier, but the company has not paid the payment to the supplier, accounts payable will appear. 

Take another example, after the logistics company has delivered the goods to the company. At this time, the company enjoyed the services brought by the logistics company, but if the company did not pay off the accounts in time, there would be accounts payable.

Transaction

There are many reasons for accounts payable. Accounts payable is very common in modern business. Reasons include but are not limited to: First, the company has insufficient cash flow and needs to get the goods, so accounts payable is generated. 

Second, suppliers reduce inventories to expand sales in a competitive market. Instead, customers are allowed to take goods and pay later. Third, the company takes advantage of its market position to take goods from suppliers first and charge them to accounts payable.

In doing so, the funds that would otherwise have been paid to suppliers could be used to supplement the company's cash flow and avoid interest charges on borrowing from other financial institutions.

Commercial paper

Commercial paper is an unsecured short-term paper issued by a company or bank. Commercial paper exists in companies as a form of short-term debt. Its reliability depends entirely on the credit of banks and companies. 

Commercial paper

Therefore, the company's credit reliability becomes the key to whether a commercial paper can be issued. For the company, issuing commercial paper as a means of financing can provide the company with more funds.

And it's cheaper than borrowing from a bank. Most commercial paper is issued to meet a company's demand for cash flow, such as payments to suppliers and payroll payments to employees. 

Or, when the company faces some debt, it can issue commercial paper to make up the capital.

The company can also look for banks to issue commercial bills for it, which the bank can examine to help the company accept and guarantee the unconditional exchange of bills after maturity.

Most commercial paper will be cashed in within a few months. Commercial paper is issued at less than face value and paid at face value when it matures. That created a profit for investors, so there was a commercial paper market.

Commercial paper can be transferred and discounted, so it is circulated among financial institutions such as banks and investment companies.

Reviewing documents

For example, Company A is one of the largest trading companies in the area. At the end of the year, they hoped to import a shipment of goods worth $10 million, but because of internal operation problems.

They could not immediately provide so much cash, so the company chose to issue a commercial paper. The company issued a note with a face value of $10.1 million. They sold the notes for $10 million and set a cash date of two months. 

So institutional investors are going to buy these notes. The company was able to raise $10 million. The investor could have made a profit of $100,000 two months later.

Advantages of Short-Term Debt

Short-term debt can sometimes be attractive to companies for certain reasons, depending on their situation. Some benefits will include: 

1. Quick access to funds

Short-term debt financing will become a very common choice when the company is faced with a tight capital chain or major events because the financing speed of short-term borrowing is relatively fast. Short-term borrowing is less complicated than long-term borrowing. 

Funds

2. Low loan eligibility requirements

The eligibility threshold for short-term borrowing is lower than for long-term borrowing. The uncertainty is lower than creditors due to the short repayment time. It's less risky for creditors, so they don't expect much from debtors. 

This is great for new businesses or businesses with a lower credit rating that cannot get approval for long-term loans.

This will help debtors get funds more quickly in an emergency. Help the company maintain good cash flow. And if short-term loans can help them tide over difficult times, they can make timely payments in the future. It helps their credit, too.

3. Short repayment period

Because it is short-term debt, the repayment period is usually within a year. The company needs to make the repayment according to the prior contract; whether it is monthly, semi-annual or annual, it will be settled within one year. 

This removes the debt from the financial books for a short period of time. The year-end financial statements will be clearer. When investors read a company's annual report, they will see that its debt is not bad, increasing their confidence in the company. 

And having less debt will make it easier for companies to raise money in the future. No one wants to lend money to a company with a lot of debt. That is too risky for creditors. But if the debt is paid off quickly. The company's credit will increase, making it easier to raise money when the company needs to expand in the future.

Disadvantages of Short-Term Debt

While having short-term debt may have benefits, it is not without disadvantages. Therefore, some drawbacks of short-term debt may include the following: 

1. Risk Issues 

Short-term borrowing, accounts payable and commercial paper depends heavily on a company's credit history. When companies use these methods to increase capital, be sure to pay it back on time. 

Disadvantages and advantages

Failure to perform on time can greatly damage the company's credit system. This will make it very difficult for companies to do deals and raise capital in the future. And failure to comply could lead to lawsuits. All these will make it difficult for the company to operate.

2. Lower interest rates

Although short-term loans have the characteristics of fast lending speed and low approval conditions, at the same time, it has brought higher interest rates. Credit requirements for companies are low, and borrowing companies often are desperate for money.

For borrowers, they have more say because they bear the risk of a debtor's poor credit record. So interest rates are usually higher than long-term loan rates. And if a payment is late, you may have to pay a higher interest rate. This can be stressful for many businesses.

3. Low loan amount

Short-term loans may not be very high loan amounts. The purpose of the short-term loan is to solve the company's short-term emergency expenses. It doesn't directly help the company do more business. And because the company needs to pay back the loan in a short time. 

This leads to the problem that if the loan amount is not too large, it does not quickly help the company solve the urgent problems facing it. Then the high-interest rate on the loan will be a burden on the company.

Conclusion

Short-term debt can sometimes be a good way to help a company raise capital or increase its current cash flow by deferring payments. 

Conclusion

Companies can get many benefits from this; for example, when the company faces difficulties, short-term debt can quickly provide the company with more cash to help the company solve the problem. 

Or companies can finance themselves through commercial paper without incurring excessive interest rates. These can give financial support to the company. But at the same time, companies also need to pay attention to their ability to repay. 

The company must pay on time and pay interest according to the contract. Only good credit will make short-term debt less of a burden and more of a way to help companies.

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Researched and authored by Lay Shang | Linkedin

Reviewed and Edited by Aditya Salunke I LinkedIn

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