As a business owner, it is important to know the difference between short-term and long-term debt. This knowledge helps keep your business financially healthy. Understanding how to manage both types of debt can help your business with payments.
Short-Term Debt
Short-term debt refers to money that is planned to be paid off within months or a year (12 months or less).
Long-Term Debt
Long-term debt refers to money that is planned to be paid off after more than a year (12 months or more).
Why Does This Matter?
While this may seem like a small difference, knowing how to use these two debts well can help your business grow in important times.
- Financial Planning: Keeping track of your debt is vital to the company’s financial health. Since debt appears on your balance sheet, it is important to list the two debts correctly. This is vital for your management and for investors watching your business’s numbers.
- Financing and Loans: Banks and lenders may look at how well your business has managed its debts in order to determine approval status. Knowing how to use both types of debt can improve your chances of getting loans approved in the future.
- Investors: As stated earlier, investors will check your debt information. This helps them see your business’s financial health. Having too much short-term debt can make your business look unreliable. On the other hand, a lot of long-term debt might make investors see your business as too risky. Making sure you can manage the two debts properly can help bring in investors to your business.
It’s essential to strike a balance between short-term and long-term debt. Relying too heavily on short-term debt can lead to cash flow issues, while too much long-term debt can leave your business with high interest payments. Reviewing your debt levels and payment schedules can help you make informed decisions about borrowing while keeping any repayments in mind.
Short-Term Debt vs Long-Term Debt: Examples
For a better understanding of how you can use these two debt types. Here are a few examples of effective usage:
Short-term Debt:
- Short-term loans: Loans that need to be paid off quickly within months.
- Accounts payable: This involves buying supplies on credit, which you will eventually have to pay off within a short period.
- Credit cards: Credit card holders should pay off balances within their billing cycle.
Short term debts are great for quick access to funds that may not be available for the business. Whether it may be an at-the-door opportunity or an urgent need, short-term debt can add those small funds that may be needed in the moment during business operations.
Real World Example
A business chooses to buy $1,000 worth of office supplies on credit from a vendor. The vendor requires that the business pay off this payment within 30 days. With this
information in mind, the business should save money from daily operations. This will help pay off the debt quickly to avoid any late fees.
Long-Term Debt
- Long-term bank loans: These are loans that are typically used for large investments like buildings. Long-term loans would also require a longer period of time before you need to pay off the balance.
- Auto/equipment loans: These help individuals purchase vehicles or equipment, which they must pay off years later.
- Mortgages: This refers to loans that people use to purchase real estate, and borrowers typically take several years to pay them off in full.
Long-term debt can be a great way to handle large investments like the ones mentioned above. Long-term investments, like properties or big projects, should be managed well.
Real World Example
A business chooses to take out a loan of $100,000 from a bank to purchase new equipment for its machinery services. The bank asks that you repay back the money within 5 years.
Additionally, remember to look over the loan terms to keep any interest in mind.
Ratios
To better understand debt management, here are some key ratios. Investors and lenders use these to assess a business's debt position.
- Cash Ratio: This measures how well your business is able to cover its short-term debts. A higher cash ratio is what you are aiming for!
- Current Ratio: measures a business’s ability to pay off short-term liabilities using its short-term assets. A Current Ratio of 2.0 means the business has $2 in current assets for every $1 in current liabilities, meaning strong liquidity.
- Quick Ratio: is a stricter liquidity measure that evaluates a company’s ability to pay off short-term liabilities without relying on inventory sales. It focuses only on highly liquid assets.
For more helpful ratios and formulas check out our Top Liquidity Metrics for Business to Business & Business to Consumer Businesses blogs.
Keep Track of Your Debt for Healthy Growth
Tracking both short-term and long-term debt is essential for any business to keep a healthy financial status. Keeping your debt in check and avoiding cash flow issues can help improve your credit. This can also attract more interest from investors.
For more help in debt management, contact our team today to assist in managing both types of debt!
