What is Long-Term Finance?
The funds that are not paid back within less than a year are referred to as long-term finance. Certain long-term finance options directly form a part of the permanent capital of the firm. In such cases, the repayment obligation does not even arise. A 20-year mortgage or 10-year treasury bills are examples of long-term finance. The primary purpose of obtaining long-term funds is to finance capital projects and carry out operations on an expansionary scale. Such sources of finance are normally invested into avenues from which greater economic benefits are expected to arise in the future.
Sources of Long Term Finance
The nature of such finance can be ownership and borrowing or a hybrid of the two. Some of the main sources of long-term finance are listed below.
Equity is the foremost requirement at the time of floatation of any company. They represent the ownership funds of the company and are permanent to the firm’s capital structure. The equity can be private or public. Private equity is raised from institutional or high-net-worth individuals. Public equity is raised by issuing shares to the public at large, which are subscribed to by retail investors, mutual funds, banks, and a pool of other investors. On the flip side, equity is an expensive variant of long-term finance. Investors expect a high return due to the extent of risk involved.
- Pro: No repayment obligation arises during the lifetime of the company.
- Con: The issue of shares via an IPO in the primary market is costly and entails several legal and banking expenses.
Bonds are debt instruments involving two parties- the borrower and the lender. The borrower can be the government, a local body, or a corporation. They provide fixed interest payments at periodic intervals and are redeemable at a predetermined date in the future. Bonds are normally issued against collateral and are therefore a highly secured form of long-term finance. Bonds may prove to be a very cost-effective source of funds in a bullish market.
- Pro: It is easier to raise funds via bonds, especially federal bonds since they enjoy complete investor confidence.
- Con: Subject to interest rate risk. Therefore the price of bonds will fall with an increase in prevailing interest rates.
Term loans are borrowings made from banks and financial institutions. Such term loans maybe for the medium to long term, with a repayment period ranging from 1 to 30 years. Such long-term finance is generally procured to fund specific projects (expansion, diversification, capital expenditure, etc.) and is, therefore, also known as project finance. Term loans can be sourced by both small as well as established businesses. Also, the interest rates are relatively low and are negotiated depending upon the duration of the loan, nature of security furnished, the risk involved, etc.
- Pro: Term loans can be sanctioned immediately within a matter of days depending upon the firm’s financial health.
- Con: Heavy collaterals are required to be furnished to obtain a term loan. Even then, the amount of loan disbursed remains a fraction of the asset value.
Internal accruals are nothing but the reserve of profits or retention of earnings that the firm has created over the years. They represent one of the most essential sources of long-term finance since they are not injected into the business from external sources. Instead, it is self-generated and highlights the sustainability and profitability of the entity. Also, internal accruals are the owner’s funds and therefore create no charge on the company’s assets.
- Pro: The firm incurs absolutely no cost in raising such funds.
- Con: It may be a source of conflict since the shareholders may prefer the payout of dividends rather than a plough back.
This form of financing has emerged with the growing popularity of start-up culture worldwide. Venture Capital (VC) firms invest in companies at their inception or seed stage. They are constantly on the watch out for firms demonstrating high growth potential. Their investment takes the form of ownership funds and forms a part of the firm’s permanent capital. Venture capitalists also have a predetermined exit strategy before they invest. This results in the target company being listed or a secondary sale to another VC firm.
- Pro: The companies that are yet to establish steady cash flows are not burdened by any covenants which entail debt financing. There is no repayment obligation until the firm is profitable.
- Con: The firm ends up losing a significant piece of the ownership pie to such Vc’s.
Short Term Vs. Long Term Finance
A comparative analysis of short and long-term financing will further aid in effectively grasping the benefits of long-term finance. Short and long-term sources of finances cater to a different set of requirements for different borrowers. The table below illustrates some points of distinction.
|Short-Term Finance||Long-Term Finance|
|Duration||Typically repayable within one year or less.||Have a longer time span varying from 1 to 30 years.|
|Requirements||Obtained to fund a temporary shortfall in the working capital, repayment of current liabilities, etc.||Obtained to fund the purchase of PPE or capital projects on a wide scale.|
|Collaterals||Do not create a charge on the assets of the firm.||Collaterals are the most primary condition for the furnishing of long-term finance.|
|Terms of loan||Interest rates are unstable and are vulnerable to inflationary forces.||Interest rates are stable, and the loan terms offer flexibility such as prepayment options, re-negotiation of interests upon improvement in credit rating, etc.|
|Volume of funds||Used to raise funds in limited amounts since they are repayable in the near future.||A large volume of funds can be obtained. However, the same is restricted to the nature of securities furnished, the credit rating of a borrower, etc.|
|Examples||Overdraft, Credit Cards, Line of Credit.||Leasing, Term Loans, Public Deposits, Bonds.|
2 thoughts on “Long Term Finance”
Very Well Explained.