Long Term Finance

What is Long Term Finance?

The funds which are not paid back within a period of 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 carrying out operations on an expansionary scale. Such funds are normally invested into avenues from which greater economic benefits are expected to arise in future.

Sources of Long Term Finance

The nature of such finance can be ownership as well as borrowing or a hybrid of the two. Some of the main sources of long term finance are listed below

Equity

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 capital structure of the firm. 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 flipside, equity is an expensive variant of long term finance. The investors expect a high return due to the extent of risk involved.

  • Pro: No repayment obligation arises during the lifetime of the company.
  • Con: Issue of shares via an IPO in the primary market is a costly affair and entails several legal and banking expenses.

Long Term Finance

Bonds

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 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: 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

Term loans are borrowings made from banks and financial institutions. Such term loans may be for the medium to long term with 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 financial health of the firm.
  • 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

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. Rather it is self-generated and highlights the sustainability and profitability of the entity Also internal accruals are owner’s funds and therefore create no charge on the assets of the company.

  • Pro: The firm incurs absolutely no cost in raising such funds.
  • Con: It may be a source of conflict since the shareholders may prefer payout of dividends rather than a plough back.

Venture Capital

This form of financing has emerged with the growing popularity of start-up culture worldwide. VC firms invest into companies at their inception or seed stage. They are constantly on a watch out for firms demonstrating high growth potential. Their investment takes the form of ownership funds and forms a part of the permanent capital of the firm. 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 who 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: 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 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 terms of the loan 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 amount 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 borrower, etc.
Examples Overdraft, Credit Cards, Line of Credit. Leasing, Term Loans, Public Deposits, Bonds.

References: 

CA Final Syllabus

Last updated on : June 9th, 2018

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