Advantages and Disadvantages of Short-Term Debt
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Written by Atila on September 17, 2008 – 8:09 pm
Short-term debt has three primary advantages over long-term debt. 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 longterm credit, and the loan agreement (or bond indenture) will have to be spelled out in considerable detail because a lot can happen during the life of a 10- or 20-year loan (or bond). Thus, if a business requires funds in a hurry, it should look to the short-term credit markets.
Second, if needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for three reasons:
1. Administrative costs are generally high when raising long-term debt but trivial for short-term debt. 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 may diminish in the near future, it should choose short-term debt for the flexibility it provides.
2. Long-term loan agreements always contain restrictive covenants that constrain the firm’s future actions. Short-term debt agreements are generally much less onerous in this regard.
3. The interest rate on short-term debt generally is lower than the rate on long-term debt because the yield curve normally is upward sloping. Thus, when coupled with lower administrative costs, short-term debt can have a significant total cost advantage over long-term debt.
