Why would a firm choose short term debt over long term debt?



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Why would a firm choose short term debt over long term debt?

1 Answer(s)


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By definition short term debt needs to be paid within a period of a few months. However by definition long term debt will be on a company's balance sheet for a much larger period of time anywhere from 1 to 10 years, will be even more sometimes. But typically 2-3 years. Like any other debt, short term and long term debt has to pay interest to its shareholders. Sorry... Will have to pay interest to the debt holders.

Many times companies will need short term working capital to finance short term projects a new initiative, a new factory or a new product launch. In such cases companies choose short term debt, because they don't have to be burdened by the interest expense for a long period of time. If they choose long term debt they will have to keep in interest of period of time as you already know interest is an expense, a long operating expense, and this money could have been profitably invested in a business.

By paying cash out as interest the company is unnecessarily losing money towards something that does not contribute to the core operations of the business. Hence companies would prefer short term debt over long term debt to finance their operations if possible. Also, many times short term debt will have lower interest rate when compared to long term debt. This is because the longer the amount of time needed by the company to repay the money, the higher the risk to the lender.

Because longer time periods, it is very difficult for anybody to say how the market or the economy or the company is going to perform, hence there is greater chance the company may not repay the money hence the interest rate of long term debt is greater. In short term debt money is lent only for a few months or maybe a year in which case there is low predictability on the company's cash flows and its ability to pay back debt and hence the interest rate of short term debt is smaller.