Long-Term Financing : Sources, Importance, Advantages & Limitations

What is Long-Term Financing?

Long-term financing represents those borrowings or loans which are offered for a period greater than one year. It can be done by issuing equity shares, debt financing, long-term loans, bonds, or leases. Long-term finance is taken either for big projects, company expansion, or financing. Usually, long-term financing deals with huge amounts. The primary objective of long-term finance is to either fund the projects that are strategically benefiting the company or help in the expansion of business operations of the company. This form of funding is generally applied to projects that would create coordination and cooperation within the organization in the subsequent years.

Geeky Takeaways:

• Long-term finance is a form of financial instrument (for example, bonds, bank loans, leases, and other types of debt financing) or any public and private equity instrument with more than one year of maturity.
• The maturity period represents the period from the date of initiation of the bonds, loans, or leases to the final repayment of the principal amount along with the associated interest.
• This form of financing involves huge amounts that are usually applied to large company projects and the expansion of the company.
• There are different sources of this type of financing such as equity capital, preference capital, retained earnings, term loans, and debentures.

Sources of Long-Term Financing

There are multiple sources of long-term financing. Some of the major sources are mentioned below,

1. Equity Capital: This equity loan or capital represents the fund raised by a company using either IPO (initial public offering) or a private investor. In both the public and private routes, the ownership of the company is diluted. However, the controlling power lies with the largest equity holder. There is no preferential right given to the equity holders and they face the highest risk among all the shareholders. This is a zero-interest long-term financing where the investors receive returns against their investment. Further, the equity holders receive a higher rate of return compared to the debt holders as they face maximum risk during repayment of their invested fund.

2. Preference Shares: Another source of long-term financing for a corporation is the preference share capital. Investors invest in these forms of shares as they have the opportunity to receive returns. Here, the preference shareholders possess preferential rights when receiving dividends and lower risk than the equity shareholders. The dividends are paid at a fixed rate and the full payment of funding is given to the preference shareholders when a company winds up their business.

3. Debentures: These are some of the commonly used financial instruments for long-term financing. Debentures are generally issued by an organization, having a fixed rate of interest, and thus the market fluctuations do not hamper the transactions for this source. These can be used for purchasing bonds or real estate whose value increases with time. Debentures can also be used as short-term financing in case of buying shares of a company or bank. Further, debentures are considered better than other financial instruments due to their liquidity, flexibility, and cover against inflation.

4. Term Loans: A loan that offers a fixed repayment period ranging from five to ten years, is termed the term loan. These are usually used to fund large projects or invest in capital expenditures such as purchasing machinery and equipment and renovations. Term loans can also be used for short-term needs such as repaying existing debt before its final repayment period.

5. Retained Earnings: It is also termed as plough-back profits. The source is a beneficial one as no charges are included in it. The profits that the company earns are used for financing its debt, paying off investors, or offering stock options to its employees. Retained earnings can be used to expand the business after repaying all the dividends and interest charges. This is a safe option as no burden of debt relies on and no dilution of ownership exists. They impact the equity share valuation and form a portion of the net worth of the company.

Importance of Long-term Financing

Long-term financing is helpful in multiple forms to run the business without a shortage of funding. The below provides the importance of long-term financing,

1. Capital Expenditures: Long-term financing is important when investing in capital expenditures such as developing infrastructure, purchasing plant and machinery, and expanding existing facilities. It offers the funding required to make significant expenditures that facilitate a company’s expansion and viability.

2. Expanding Business: By providing the funds required to introduce new products, penetrate new markets, or buy out rival companies, long-term financing makes it easier for firms to grow. For businesses looking to become more competitive and visible in the market, this monetary assistance is necessary.

3. Liquidity and Stability: An organization’s stability and liquidity are enhanced by long-term funding. It lessens the need for short-term debt and lowers the chance of experiencing financial difficulties by ensuring a steady and dependable supply of financing over a longer period. The corporation’s financial status as a whole is improved by this stability.

4. Manage Debt and Cost Efficiency: Long-term financing enhances the debt management of the business and strengthens its capital structure. Generally, long-term finance offers lower interest rates than short-term ones, thus the cost efficiency of the business can be improved along with providing less burden due to the financing over time. Long-term financing is a sought-out debt management that enhances the overall financial health of the company.

5. Research and Development: Long-term financing is beneficial in supporting the research and development centers of the business. For innovation and improvement of business operations, funding in R&D is crucial, and long-term investments enhance this procedure. There won’t be extra pressure on repaying the funds rather the business can concentrate on innovating new products and services to compete in the market.

Advantages of Long-Term Financing

Long-term financing comes with several advantages which are as follows,

1. Larger expenses are affordable: Long-term financing helps businesses to afford capital expenditures such as buildings and equipment. They can fulfill the long-term capital goal of the business. If more capital expenditure and assets are available, then it can support the growth and expansion of the business.

2. Better Repayment Options: The repayment procedure of long-term financing is flexible. For instance, the longer the repayment period, the monthly payment amount becomes smaller. Businesses and financial institutions prefer long-term financing as they get a longer repayment period and they can gain a stable income flow. Further, they must ensure that they can pay off their monthly dues.

3. Credibility Increases: Engaging in long-term financing, businesses can grow their credit by ensuring investors that they can repay their loans. This helps in enhancing collaborations among investors and corporations. More larger and better opportunities for borrowing build up in the future. Further, regular payments by the borrowers are necessary to maintain the status quo.

4. Financial Flexibility: Long-term financing offers financial flexibility by providing funding that helps in affording different activities, expenses, and projects. Further, by taking loans, borrowers can invest to generate extra earnings. Advance payments are also possible in long-term finances. This will allow a lower monthly repayment condition and the loan can be repaid within a short period. In this condition, one can avail of a long-term loan but enjoy the benefits of a short-term loan.

Limitations of Long-Term Financing

Apart from the benefits, long-term financing has certain limitations which are as follows,

1. Higher Interest rates: Due to its longer repayment period, there is a risk associated with the lenders. Although there is a steady flow of income for an extended period, there is an increased risk for the same long period. Thus, the lenders offer higher interest rates to cover the increased risk. This process also helps lenders protect them from inflation risk, as when they receive their amount back, the value of the amount won’t remain the same as it was at the time of lending.

2. Risk of Losing Collateral: While availing the long-term finance, the borrower puts up their asset as collateral. Hence, if the borrower is unable to repay the loan, there is a high chance of losing the collateral. As for the lender, as the amount of the funds is high and the repayment period is long, to combat the risk collateral is required by the lender. Therefore, being a borrower they face the risk of losing their collateral until the debt is completely paid off.

3. Stricter Terms and Conditions: Another disadvantage of availing of long-term financing is that it demands too much crucial information about the borrower. Similar to personal loans, business loans offered by financial institutions or corporations look back into the financial history and from profitability to the history of repaying loans. Lenders look for reliable borrowers as long-term financing involves huge sums of money and longer repayment periods. Hence, if any borrower has no credit score, availing of this form of financing would be a bit difficult.

4. Maintaining Longer Duration Repayment Period: The repayment period is so long that this might impact the credit score and make the cash flow negative until a strong debt repayment strategy is built. Long-term loans require monthly repayments for a long duration on a consistent basis and if one fails to be regular in repaying, then it would impact their credit score. later on, this would create a hard time in availing another loan in the future.

Long-Term Financing – FAQs

What factors do the investors look for while evaluating the eligibility of a business for lending long-term finance?

When evaluating a company’s eligibility for long-term financing, lenders take into account a number of variables. Important factors to take into account are the company’s creditworthiness, stability, past performance, projected cash flow, collateral, and intended use of the funds. A strong business plan and a track record of producing enough cash flows to pay off the loan are two of the most important requirements that lenders look for before granting long-term financing.

Is purchasing equipment long-term financing?

The purchasing of equipment can be considered long-term financing as this involves borrowing money for buying capital assets which would offer benefit in the future.

What is the difference between long-term financing and short-term financing?

Long-term financing represents the funds which comes with a maturity period of more than one year. Whereas, in short-term financing. the maturity period is less than one year. Further, long-term financing is used for capital expenditures or to fund current operations, while the short-term financing covers temporary cash flow needs and supports the working capital.

Are commercial papers a source of long-term financing?

No, commercial papers are not generally a source of long-term financing, as they have a maturity period of 270 days (short-term debt instrument). However, sometimes, commercial papers might be issued for a period of 1 – 2 years (intermediate-term financing).

What are the common sources for long-term financing?

Long-term financing can be availed by businesses from several sources such as bank loans, equity financing (issuing common stock or preferred stock), private placements and corporate bonds. Different sources has its pros and cons, terms and conditions. The choice of source depends on the business’s financial status, growth strategies and risk tolerance.