Short-term vs. Long-term Loans

4 Essential Factors to Consider for Your Business

When it comes to financing, business owners have a big decision to make: short-term or long-term loans? Each type of loan has its own purposes and considerations. Let’s have a look at how short-term and long-term loans may impact your business and important tips to help make the best decision.

Short-term loans

Short-term loans are ideal for immediate needs. If you need to buy inventory or raw materials fast, a short-term loan can get the funds you need in a jiffy. You’ll pay it off fast too, in theory, since you’re going to sell the products quickly, making these loans cost-effective with lower interest rates compared to long-term loans.

For instance, let’s say your company needs to stock up on inventory for the holiday season. A short-term loan can provide the quick cash infusion necessary to purchase the products, and once they sell, you can repay the loan. Plus, if you’re dealing with accounts receivable—selling products or services on credit and waiting for payments—short-term loans can help bridge that gap and keep your cash flow steady.

Long-term loans

Long-term loans are ideal for significant investments that don’t pay off immediately. Think big projects like constructing a new building or buying major equipment. These loans stretch over several years, allowing you to spread out the cost and align payments with the long-term benefits and revenue generated by the asset.

For example, let’s say you’re opening a new store. A long-term loan can help finance the construction and setup, giving you the breathing room to pay it back gradually as your store starts making money.

What is important to understand

There are a few considerations when choosing between a short-term loan and a long-term loan.

1. Match the loan term with the life of the asset

Matching the loan term with the life of the asset is important for keeping your business financially stable. It means your debt repayments sync up with the revenue your asset brings in. This way, you avoid the stress of short-term loans needing quick repayment before you see any returns, and you don’t get stuck with long-term loans dragging on past the asset’s useful life. By matching the loan term with the life of the asset you can manage debt more smoothly, plan and budget more easily, while setting your business up for sustainable growth.

2. Be careful with interest rate speculation

Choosing a long-term loan because you think rates will rise or avoiding one because you think rates will fall is a gamble. If rates don’t move as predicted, it could backfire. Opting for a variable-rate loan over a fixed-rate loan, for instance, is essentially betting on future interest rate changes. This can work if your business is risk-tolerant and can handle the fluctuations as well as an element of uncertainty that can be carefully managed. But if your business cannot handle the fluctuations, it can lead to cash flow trouble. When it comes to interest rates, it matters more what your budget is rather than what the interest rates may be.

3. Stand by your cost-benefit calculations

The value of a cost-benefit analysis is that it helps businesses evaluate the financial viability and potential returns of an investment – which helps inform what type of loan to get and if it makes sense to get one. This analysis provides a clear picture of the net benefits,  highlighting the profitability and identifying potential risks, and allowing businesses to make the best decisions for the financial health of the company.

What can happen sometimes is that business owners get caught up in the dream and so they change the calculations to make the dream work. Yes this happens! To prevent cash flow troubles, stand by your initial cost-benefit analysis and plan accordingly.

4. Do a sensitivity analysis before getting a loan

What if your sales are 10% less or 25% less than you expected? Or what if sales are 10% more than expected? What will this mean and how much of a variance in sales can you afford before this is a problem? Consulting with your trusted Finactics accountant to do a sensitivity analysis will help you understand the different variables that can impact your financial outcomes and better ensure the investment will be in your favour.

Need help with a cost-benefit analysis or sensitivity analysis? Our team at Finatics can help. Get in touch here.