Many promoters do not know the difference between Short term loans (less than 6 months) and long term loans (more than 2 to 3 years) and because of which may take some risky decisions which can put an organization survival at stake. At the core of the difference is the concept of “Purpose of Application”. Short Term Loans are raised to manage general working capital gaps of day to day operations whereas, Long Term Loans are raised to meet capital expenditure and are to be repaid over a fixed tenure in fixed or variable periodic repayment schedules.
Incase promoter is in need of buying a property or invest in a project, where the return on investment shall not happen till the property or project start returning in surplus, he will not be in a position to repay the loans, in these cases, he should take Long Term Loans which have long payment duration. (Example: New Retail Branch Expansion (including stocks), New Power Project, New R&D Initiative, New Machinery Installation etc.,). Imagine if short term loans (which generally come at a higher interest rate) are used to invest in property or projects, they may not be able to return you the funds immediately and your short term capital is stuck. This is a vicious cycle.
On the other hand, Short Term Loans are taken to bridge a temporary working capital gap due to exigencies in the nature of business (Ex: Sudden spike in Inventory requirement due to surge in demand, Delay in collecting specific Receivable from a Customer, a forecasted gap in cash flow for few weeks due to collection & payment mismatches, Purchase of regular requirements of IT machinery,). It may be noted that, for Short term working capital requirements can also be met through Long Term Loans, incase you have prudent & strong finance management practices.
There are numerous examples of companies going bust because of diverting short term loans / capital to long term requirements when driven by over optimistic impression on their business plans. Hence, it is better prevented than cured.
Author : Kalyan Kumar G