Short-Term Financing
The three possible short-term financing policies described earlier were distinguished
by the relative amounts of short-term debt used under each policy. The aggressive pol-
icy 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 gener-
ally 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.
Advantages of Short-Term Financing
First, 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 be-
cause 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.
Second, if its needs for funds are seasonal or cyclical, a firm may not want to com-
mit itself to long-term debt: (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 provi-
sions, or covenants, which constrain the firm’s future actions. Short-term credit agree-
ments are generally less restrictive.
Third, 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.
Disadvantages of 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.
What are the advantages and disadvantages of short-term debt over long-term
debt?
Short-Term Bank Loans
Loans from commercial banks generally appear on balance sheets as notes payable. A
bank’s influence is actually greater than it appears from the dollar amounts because
banks provide nonspontaneous funds. As a firm’s financing needs increase, it requests
additional funds from its bank. If the request is denied, the firm may be forced to
Short-Term Bank Loans 607
602 Working Capital Management
