Like many banking and accounting terms, short-term credit is often misunderstood and misused. To a bank, short-term credit is a generic term for a revolving line of credit granted to a business or an individual, or a fixed loan with a term of one year or less. On your financial statement, the section labeled short-term credit (or notes) refers to the amount of debt you have to pay off within the next 12 months, even if it is part of a long term loan. The deciding factor on whether a loan is considered short term is when it expires.
Why it Matters
To understand why it matters whether credit is deemed long-term or short-term, you need an understanding of the cash flow process. Cash comes into businesses at different rates depending on their business cycle. Sometimes there is steady monthly flow; others get money in chunks throughout the year. Banks have designed loans to assist companies in smoothing out their cash flow so they can meet expenses on a consistent schedule.
Matching The Purpose
The lending process involves several steps and many questions on the part of the banker. First among them is identifying the source of repayment for a loan. The two types of loans are short-term, anything with a maturity in one year or less and long-term, everything else. Long-term loans, like those for equipment or real estate, are said to be paid by the profits a business makes. Short-term loans are paid through cash flow activities conducted through the month.
Short-Term Credit Purposes
Short-term credit is typically used to meet an immediate but recurring expense. An example is payroll. If a company bills weekly and is paid two weeks later, there is a cash flow deficit. A short-term credit facility, also known as a line of credit, could be used to cover the payroll until the invoice is paid. When the payment is received, the line of credit is paid off until it is needed again. Another example of short-term credit is accounts receivable financing where you use the loan to purchase raw materials and finance the invoice when the product is shipped.
Other Short-Term Needs and Limitations
A less commonly known form of short-term credit is the short-term loan. This term applies to any loan with a maturity in less than one year. These short-term credits are used for single-purpose, immediate needs. An example is a one-time opportunity to buy and sell quickly a piece of equipment at significant profit. The bank might lend you the money necessary to make the deal with your agreement to pay it back in 30 or 60 days. The bank will always try to match short-term credit with short-term needs. The bank will also require you to pay the short-term credit line down to zero and keep it there for 30 days each year.
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