The length of finance received by a business can dictate many factors related to it. These factors may include the amount of finance received, the interest rate or return the business must provide for it, the repayment schedule, etc.
It also means that the business must decide beforehand how much and for how long it requires finance.
Usually, the most common options that a business has are short-term and long-term finance, when it comes to the length of finance.
Short-term finance is the type of finance a business requires for temporary activities. These may include funding working capital needs or meeting temporary cash shortage problems.
Short-term finance, as the name suggests, spans for up to 2 years. Short-term finance comes with higher interest rates and a busier repayment schedule as compared to long-term finance.
Long-term finance, on the other hand, is the type of finance that a business requires for long-term needs and operations. For example, it may obtain long-term finance to finance expansion projects or acquisitions.
Long-term finance consists of any finance with a length of 5 years or more. Usually, these may include long-term loans or owners’ equity.
Long-term finance may come with lower interest rates and a relaxed repayment schedule as compared to short-term finance. However, in the long run, they are more expensive for business.
Another option that the business may have is medium-term finance. While not as common as the above two types, it is still an option that it can use for specific purposes.
Medium-term finance consists of any finance that the business receives for a period between 2-5 years. The main purpose businesses use medium-term finance is to finance expansion projects or purchase fixed assets.
However, as compared to long-term finance, these projects may be of lower capacity. Similarly, businesses that expect higher returns from projects in a short amount of time may also prefer medium-term finance over long-term finance.
Usually, medium-term finance only includes loans or other debt instruments, as equity is long-term finance.
Medium-term finance, as compared to the other two options above, can have advantages and disadvantages for the business.
4 Limitations of Medium-term finance
The limitations of medium-term finance for a business include the following.
1) More difficult to obtain
Medium-term finance is more difficult to obtain as compared to short-term finance. That is because the financial institution, or lender, providing the loan will generally require the business, or borrower, to meet a specific credit rating.
The finance may also come with some other requirements from the lender. For borrowers that do not have the required credit score, medium-term loans may not be an option.
Similarly, some types of medium-term finance may require the business to offer collateral in exchange for the loan. For small businesses and startups, that may not be possible.
2) Longer approval process
Due to the extra checks on the borrower, medium-term finance may have a long and lengthy approval process as well. Apart from the checks, lenders may also require some other extensive documentation that supports the financial capacity of the business to repay the loan.
For small size businesses and startups, this may take even longer due to no credit histories. Therefore, medium-term finance can be disadvantageous for those businesses looking for quick ways to finance activities.
Similarly, the lengthy process does not guarantee a borrower will receive the loan. So, the borrower always faces the risk of waiting through the process and not obtaining a loan at all.
3) Higher fees and penalties
Some forms of medium-term finance may also come with high fees and penalties. They may consist of origination fees, which includes costs which the lender incurs due to the processing of the information related to the borrower.
However, the lender charges the borrower for this cost. Similarly, the penalties include prepayment penalties, which is the penalty that the lender charges the borrower if the borrower pays the loan before the specified maturity.
Prepayment penalties are less common as businesses are less likely to return finance before the specified time. However, they still exist in medium-term finance.
4) Accrued interest
Medium-term finance may also result in high accrued interest for the borrower. The accrued interest depends on the interest rate of finance.
Accrued interest generates when the finance spans over several years. Accrued interest makes finance more expensive as compared to a short-term loan. Accrued interest is a common problem with long-term finance as well.
Businesses can obtain finance for different periods. Most commonly, they use short-term and long-term finance. However, they can also use medium-term finance, although it is not as common.
Medium-term finance consists of funds that businesses receive for 2-5 years. They use these funds for specific purposes.
The limitations of medium-term finance include difficulty to obtain, longer approval process, higher fees and penalties, and accrued interest.