Question

outline the advantages of using short term debt as opposed to long term debt in the financing of working capital.
support with references

Answer 1

Long-term financing helps position companies for long-term initiatives and to better manage financial risk.

The benefits of long-term and short-term financing can be best determined by how they align with different needs. Companies typically utilize short-term, asset-based financing when they’re first getting off the ground, and in general, this type of financing is used more for working capital. After a company grows beyond short-term, asset-based loans, they will typically progress to short-term, cash-flow based bank loans. At the point when a company starts to gain scale and establish a track record, they may access either cash-flow or asset-based, long-term financing, which has several strategic benefits.

The Benefits of Long-Term vs. Short-Term Financing

The benefits offered by long-term financing compared to short term, mostly relate to their difference in maturities. Long-term financing offers longer maturities, at a natural fixed rate over the course of the loan, without the need for a ‘swap.’ The key benefits of long-term vs. short term financing are as follows:

1. Coincides with Long-Term Strategy – Long-term financing enables a company to align its capital structure with its long-term strategic goals, affording the business more time to realize a return on an investment.
2. Matches Duration of Asset Base with Duration of Liabilities – The maturity associated with long-term financing better coordinates with the typical lifespan of assets purchased.
3. Long-Term Support from Investor – A company can benefit from having a long-term relationship with the same investor throughout the life of the financing. With the right investor, companies stand to gain from a long-term relationship and partnership, in addition to ongoing support. Being that the financing is long term, a company will not have to repeatedly bring in new financing partners who may not understand the business as well, which can often happen with short-term financing.
4. Limits Company’s Exposure to Interest Rate Risk – Long-term, fixed-rate financing minimizes the refinancing risk that comes with shorter-term debt maturities, due to its fixed interest rate, thus decreasing a company’s interest rate and balance sheet risk.
5. Diversifies Capital Portfolio – Long-term financing provides greater flexibility and resources to fund various capital needs, and reduces dependence on any one capital source. It also enables companies to spread out their debt maturities.

The Differences Between Long-Term and Short-Term Financing

To fully understand the benefits, companies should also get acquainted with all of the differences:

Short-term financing is usually aligned with a company’s operational needs. It provides shorter maturities (3-5 years) than long-term financing, which makes it better-suited for fluctuations in working capital and other ongoing operational expenses. Traditionally, short-term financing is provided by banks and has floating interest rates. Sometimes companies will artificially ‘fix’ these floating rates with a financing derivative, such as a swap.

Many companies consider long-term financing to be ‘patient’ financing, given its longer maturities (5-25+ years). Long-term financing is ideal for businesses seeking to extend or layer out their refinancing obligations beyond the typical bank tenor. Longer maturities often allow for delayed, limited or no amortization, which can be attractive to companies with objectives such as buying out a shareholder, investing in capital assets, projects or acquisitions, that have a longer investment return runway.

"A long-term, largely fixed-rate balance sheet can enable companies to better manage financial risk should interest rates rise."

It is common for long-term financing to also have a fixed-interest rate. A long-term, largely fixed-rate balance sheet can enable companies to better manage financial risk should interest rates rise. As previously mentioned, a business would also have more time to pay back the financing, while having certainty of financing cost over the life of an investment.

Long-term financing providers are typically institutional investors, such as large insurance companies, that given their capital base, have consistent capacity to lend on a long-term basis.

Uses for Long-Term Financing

Long-term capital is congruent with a company’s long-term, strategic plans. Thus, it is most commonly used to support long-term initiatives, such as making acquisitions, opening a new production facility, financing internal events (like share repurchases) as well as preparing for rising interest rates; some companies choose to operate with a minimum level of debt on their balance sheet to maximize their balance sheet efficiency – managing interest rate risk for this is important and makes it a great fit for long-term capital.

Here is a broader range of how companies, both public and private, use long-term financing:

Long-Term Financing Example

MGP Ingredients: Obtained long-term financing for expansion and growth

For MGP Ingredients, Inc. (“MGP”), investing in capex and their product inventory is instrumental to their long-term business strategy. Headquartered in Atchison, KS, MGP is a producer and supplier of premium distilled spirits, specialty wheat protein and starch food ingredients.

Prudential Private Capital’s relationship with MGP began in early 2017 with a meeting to discuss MGP’s business model as well as future capital needs. MGP had previously used a combination of cash flow generation and borrowings under its bank credit line (‘revolver’) to fund a warehouse expansion project and to build up aged whiskey inventory. In 2017, MGP elected to borrow long-term, fixed-rate senior debt to term-out a portion of its revolver borrowings, and to fund incremental investment in capex and aged whiskey inventory. Having long-term useful lives, these investments were aligned with the long-term financing the company was looking for.

MGP obtained a $75 million Pru-Shelf facility from Prudential Private Capital, and received an initial draw of $20 million of long-term, fixed-rate senior debt. MGP was ultimately able to maintain a close-knit lender group, with a single capital provider for fixed-rate debt. They also valued Prudential Private Capital’s relationship-focused approach and the ability of the long-term financing to support the company’s future growth plans.

Essentially, the type of capital companies select will depend on the needs of their business. Long-term capital is better-suited for external and internal strategic investments as well as financial risk management, in contrast to short-term capital, which is best used for every-day, operational needs. At Prudential Private Capital, we know it can be difficult to know which option is the right choice; we are here to help companies access the type of capital that sets them up to grow for the long run.