A business relies on finance to support its operations. This finance may come in different forms such as equity, debt or even hybrid finance, which is a combination of debt and equity. Each type of finance comes with its costs.
Therefore, the business must determine the reason it needs finance and the best way to obtain it. Due to the costs involved, businesses cannot keep finance for a long time. Therefore, they must also decide whether they need finance for the long- or short-term.
Long Term Finance
For businesses, long term finance refers to any finance that lasts for more than one year. The most common type of long-term finance for businesses is owners’ capital or shareholder’s capital obtained through their distribution of ownership.
However, it may also include long term loans obtained from financial institutions, capital leases, or even retained earnings generated internally.
The purpose of long-term finance for businesses is to finance long-term projects such as specific projects or expansion strategies. These long-term projects are usually a part of the strategic planning of a company. As mentioned above, the length of the finance also dictates their cost for a business.
However, longer-term finance has lower interest rates, while short-term finance usually comes with a higher interest rate. Therefore, businesses should use long-term finance as compared to short-term finance when it comes to financing strategic plans.
Sources of Long-Term Finance
As mentioned above, long-term finance may come from different sources, such as the owners of a business or a financial institution. Some of the most common sources of finance are listed below.
The most reliable source of long-term finance is the owners’ capital. For companies, owners’ capital may come in the form of investment in shares, hence, known as shareholders’ capital. The capital invested in a business by its owner may have its advantages and disadvantages.
Usually, the owners of a business do not need their investment repaid. That allows a business to use capital without any restrictions or worry about how to repay it.
However, as compared to other types of finance, equity finance is costlier in the long run, as it can cause a dilution of ownership of the business and require higher returns.
Businesses can also obtain finance through debt. Debt may come in many forms, such as loans from a bank, or bonds issued by companies.
Debt is an alternative option for capital and costs lower as compared to equity finance. Debt does come with several other features that are not a part of equity finance.
For example, businesses have to pay interest on debts they acquire, usually at a predetermined rate. Similarly, they have to pay interest regardless of whether there is a profit or a loss. However, these interests come with tax-saving benefits for businesses, which is not the case with equity.
Businesses can also generate long-term finance through hybrid instruments, that consist of features of both debt and equity finance. Hybrid finance is not as common among businesses because they use it as a last resort when they cannot obtain other types of finance.
Similarly, they use hybrid finance in specific cases, which may not apply to other types of finance. Mostly, only companies use hybrid finance. One of the common types of hybrid finance is mezzanine finance.
Retained earnings are the profits of a business, which it keeps after paying dividends to its owners. Retained earnings is technically a part of equity, but unlike the other options above, retained earnings is an internally generated source of finance.
Retained earnings are very beneficial as a long-term source of finance as they cost the least. The goal of accumulating profits for businesses is to use them in long-term projects or activities, which means retained earnings is also a reliable source of long-term finance.
Advantages of Long-Term Finance
There are certain advantages of long-term finance for a business. First of all, businesses use long-term finance to fund strategic activities, which can help in the long-term success of a business. Similarly, long-term finance can help a business in building synergies.
Furthermore, long-term finance comes with flexible repayment options, which allows them to repay them in a controlled manner. Overall, long-term finance can help in the growth and expansion of a business.
Disadvantages of Long-Term Finance
Long-term financing may also come with some disadvantages. First of all, long-term finance may come with certain conditions or regulations, especially long-term debt finance.
Similarly, long-term finance can affect the capital structure of a business and may also affect some of its ratios. Due to the higher finance and regulations involved, long-term finance may also need additional monitoring and control to ensure proper operations.
Businesses can obtain short- or long-term finance to fund their operations. Long-term finance generally helps businesses in achieving their long-term strategic goals.
It may come from different sources such as equity, debt, hybrid instruments, or internally generated retained earnings. Overall, long-term finance may have its advantages and disadvantages. Ultimately, which type of finance a business uses depends on its requirements.