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The primary difference between long-term and short-term financing is in the length of time the debt obligation remains outstanding. Short-term financing involves a loan term that is typically less than one year. Conversely, long-term financing is any debt obligation with a loan term that is greater than one year. The distinction is important for accounting and tax purposes.
Businesses keep a close eye on the money they make and the bills they owe. Anything that is not paid immediately is financed. Financing is a type of credit or loan that allows a business to take possession of an asset in the present but not pay for it until some time in the future. The financing obligation is carried in the company's accounting system as a liability, or an outstanding amount owed.
The evaluation of assets and liabilities allows a person to determine the financial health of a company at any particular time. If a company more assets than liabilities, it is in relatively good shape; however, if it has more liabilities than assets, it could be in trouble. There is a distinction to be made regarding types of liabilities, however, that relates to a company's operating cycle.
When a person is trying to figure out if a company makes enough money to keep up with its expenses, it is concerned with what the company makes and what it owes within an operating cycle. An operating cycle is typically a fiscal year. Anything that happens within the fiscal year is considered current, or short-term, while anything that happens outside of the one-year window is considered fixed or long-term.
From a financial management perspective, the categorization of debt as long-term and short-term financing relates to this analysis. Not only does the difference between long-term and short-term financing concern the underlying payment terms, it also dictates how liabilities are carried on the books and how taxes are paid. Short-term financing, also called current liabilities, are debts that can be paid off within the current operating cycle. These obligations directly affect cash flow and are included in any analysis of a company's liquidity. Current liabilities can also be expensed, or deducted, in the current year against revenue for income tax purposes.
Long-term financing, also known as long-term liabilities, are debt obligations that have multi-year payment terms. An example is a 15-year mortgage. The payments made on this type of financing are not included in an analysis of a company's cash flow or ability to pay monthly bills. Also, the payments are often treated differently for tax purposes. Tax codes typically require companies to spread out any deductions that the company is entitled to because of the long-term financing or the asset it enabled the company to acquire over the life of the loan, instead of placing the whole transaction in one year.
Although short-term financing can be helpful for immediate needs, such as to fund major projects, the shorter term of the loan often comes with higher interest rates and more fees.
Lenders need to make money on any loan. A long-term loan, whether it has a five-year, 15-year or 30-year term, compounds interest over time, and the lender knows it will get steady interest for the life of the loan.
However, with a short-term loan, the lender needs to pass the interest and costs of the loan on to the borrower up front, to make money and to provide protection against failed short-term projects that would leave the borrower unable to pay.
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