Question

Companies can use three basic type of financing in their business – short-term debt, long-term debt and equity. Briefly discuss the nature of each and give examples. What are the possible consequences if a company uses short-term debt to fund long-term projects, and uses long-term debt or equity to pay current liabilities?

Answer 1

Short-term debt are usually for a period of 12 months and are current liabilities in nature.

Examples of short term debt

• short term bank loan (repayable in 12 months)
• Accounts payable
• Wages payable
• Income tax payable
• Accrued liabilities payable in a year

Long-term debt are usually for a period of greater than 12 months and are long term in nature

Examples of long term debt

• Long term bonds
• Notes payable
• Lease obligations beyond a year
• Long term bank loans
• Debentures

Equity is capital contributed by shareholders. It can be contributed through initial public offer or follow on public offer or rights issue.

When company uses short term debt to meet long term projects there is risk of non payment of debt since long -term projects requires considerable time and involves gestation period. There will be mismatch of cash flow to repay short term debt. Also company may need more working capital to meet day to day requirements.

If long term debt or equity is used to pay current liabilities it means company does not have cash flow from operations and there is risk of default of debt repayment. It will affect the solvency of the company.