Advantages of Long Term Financing

Posted in Business Management, Financial Accounting on Apr 25th, 2015 | 0 comments

What is Long Term Financing?

It is a form of financing that is provided for a period of more than a year to those business entities that face a shortage of capital.

Before delving into the advantages of long term financing I would like to present you few fascinating facts on the economy that will blow your mind.

Dell “has spent more money on share repurchases than it earned throughout its life as a public company,” writes Floyd Norris of The New York Times.

According to Forbes, if a Google employee passes away, “their surviving spouse or domestic partner will receive a check for 50% of their salary every year for the next decade.”

Start with a dollar. Double it every day. In 48 days you’ll own every financial asset that exists on the planet — about $200 trillion. Wow…

According to Bloomberg, “Americans have missed out on almost $200 billion of stock gains as they drained money from the market in the past four years, haunted by the financial crisis.

The “stock market” began in May 17th, 1792 when 24 stock brokers and merchants signed the Buttonwood Agreement.

The Securities Exchange Act of 1934 creates the Securities and Exchange Commission, charged with the responsibility of preventing fraud and to require companies provide full disclosure to investors.

Wall Street was laid out behind a 12-foot-high wood stockade across lower Manhattan in 1685. The stockade was built to protect the Dutch settlers from British and Native American attacks.

Sources of Long Term Finance

Long-term loans (External)
Issue of shares or equity
Sale and leaseback (Internal)
Retained profit

Examples of long-term financing include – a 30 year mortgage or a 10-year Treasury note.

Purpose of Long Term Finance

• To finance fixed assets.
• To finance the permanent part of working capital.
• Expansion of companies.
• Increasing facilities.
• Construction projects on a big scale.
• Provide capital for funding the operations.

Factors determining Long-term Financial Requirements

• Nature of Business
• Nature of Goods produced
• Technology used

Let us look at some of the Advantages of going for a Debt Financing Option

1. Debt is the cheapest source of long-term financing. It is the least costly because interest on debt is tax-deductible, bondholders or creditors consider debt as a relatively less risky investment and require lower return.
2. Debt financing provides sufficient flexibility in the financial/capital structure of the company. In case of over capitalization, the company can redeem the debt to balance its capitalization.
3. Bondholders are creditors and have no interference in business operations because they are not entitled to vote.
4. The company can enjoy tax saving on interest on debt.

Disadvantages of Long Term Debt Financing

• Interest on debt is permanent burden to the company:  Company has to pay the interest to bondholders or creditors at fixed rate whether it earns profit or not. It is legally liable to pay interest on debt.
• Debt usually has a fixed maturity date. Therefore, the financial officer must make provision for repayment of debt.
• Debt is the most risky source of long-term financing. Company must pay interest and principal at specified time. Non-payment of interest and principal on time take the company into bankruptcy.
• Debenture indentures may contain restrictive covenants which may limit the company’s operating flexibility in future.
• Only large scale, creditworthy firm, whose assets are good for collateral can raise capital from long-term debt.

Financing through Debt Vs Equity

There are a number of ways to finance a business using debt or equity. Though the first choice of  many small-business owners would be equity, they may also prefer to utilize some type of debt to fund the business rather than take on additional investors.

When done the right way, long-term debt financing provides a number of advantages to the business and its owner.

Term Loans from Banks

Most banks provide term loans, a major source of long-term debt for small businesses, the period ranging from 3 to 10 years.  By using long-term debt, an owner leverages her personal investment to increase her returns.

If an owner contributes $100,000 in equity and obtains a $200,000 term loan, the company has $300,000 to invest. If the company generates a net income of $150,000 for the year, the owner’s monetary return would be $50,000 and her return on equity would be 50 percent. If instead, the owner had contributed $300,000, her return on equity would only be 16.7 percent. Courtesy: chron.com

The Real Benefits of Long Term Financing

• Generating money to start a new venture or to expand an existing business can be a challenge for small businesses.
• Long-term debt financing provides them with access to cash for growth in exchange for periodic installments.
• How much cash is available to a business will depend on several factors, such as the business’ credit history and its debt to equity ratio.

• Long-term financing provides businesses and individuals with a more stable debt management instrument than a short-term loan.
• Unlike certain short-term loans–such as credit from a supplier–which may be recalled at short notice due to lack a formal agreement, long-term loans are detailed in formal contracts, and the installments are either at a fixed rate or at a variable rate determined by the market.
• Long-term financing allows borrowers to have more security when budgeting for costs and expenses.
• There are a wide variety of long-term debt financing options available to borrowers, such as mortgages, leases, reverse mortgages, and loan refinancing, which can be fine-tuned to meet the borrower’s needs. This allows more flexibility and control over spending.
• For instance, a lease is a special type of long-term debt-financing instrument that allows you to benefit from the use of an asset in exchange for rental payments without having to purchase the asset.
• This is particularly useful when dealing with assets that have a predictable lifespan and that are closely linked to a company’s productivity, such as machinery and vehicles.

Long Term Financing is Regular and Structured

In contrast to short-term loans, such as credit from a supplier, which changes over time and requires regular monitoring, long-term financing is regular and structured.

Although long-term debt instruments require you to provide extensive information to the lenders, once they are secured they require minimal maintenance. This reduces the work hours required to maintain the loan.

Capital Investment

Unlike short-term loans, which are used as a quick source of cash to tide over short-term liquidity problems, long-term debt financing is used for capital investments.

Capital investments, such a real estate, machinery, vehicles, furniture and leases, provide real benefits to a company by either increasing its productivity or expanding its operating capacity.

For example, a successful restaurant can use a mortgage — a classic example of long-term debt financing — to open a new location and increase its profit potential.

Curated from The Advantages of Long-Term Debt Financing | Business & Entrepreneurship – azcentral.com