Short-Term vs. Long-Term Financing: Sources, Costs & Trade-offs

TAKEAWAYS

• Short-term financing (≤1 year) covers operating gaps (e.g., seasonal demand) via trade credit, bank overdrafts, or factoring, but carries higher risk if mismanaged.
• Long-term financing (≥5 years) funds capital assets (e.g., hotel expansion) via loans, bonds, or equity, with lower cost but stricter covenants.
• The cost of not taking discounts (e.g., 2/10 net 30) can exceed 30% annually—calculate it using the formula: $$\text{Annual Cost}=\frac{\text{Discount \%}}{100-\text{Discount \%}}\times \frac{360}{\text{Net Days}-\text{Discount Days}}$$
• Trade credit (supplier financing) is the cheapest short-term source but may strain supplier relationships if overused.
• Debt vs. equity trade-off: Debt is tax-deductible but increases financial risk; equity dilutes ownership but improves stability.
• Leasing (operating vs. financial) lets hotels acquire assets (e.g., kitchen equipment) without large upfront costs.

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1. Short-Term Financing: Sources, Mechanics, and Costs

Short-term financing bridges cash flow gaps (e.g., paying suppliers before receiving customer payments). Common sources in Nepal:

A. Trade Credit (Most Common in Nepal)

• Definition: Delayed payment terms offered by suppliers (e.g., "2/10 net 30" means 2% discount if paid in 10 days, else full amount due in 30 days).
• How it works:
  • Example: A Kathmandu restaurant buys Rs 500,000 worth of ingredients from a supplier with terms 3/15 net 45.
    • Option 1: Pay Rs 485,000 (500,000 − 3%) within 15 days.
    • Option 2: Pay Rs 500,000 at day 45.
  • Cost of not taking discount: $$\text{Annual Cost}=\frac{3}{97}\times \frac{360}{30}=36.39\%(\text{Very expensive!})$$

B. Bank Overdrafts and Short-Term Loans

• Used for: Unexpected expenses (e.g., staff salaries, utility bills).
• Cost: Higher than long-term loans (e.g., 12–18% p.a. in Nepal).
• Risk: Banks can demand immediate repayment.

C. Commercial Paper and Factoring

• Commercial Paper: Unsecured promissory notes issued by large firms (rare in Nepal; used by Ncell or NTC).
• Factoring: Selling accounts receivable to a factor (e.g., a hotel sells unpaid guest bills to a factor for 80% upfront).

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D. Real-World Example: Daraz’s Supplier Financing

• How Daraz uses trade credit: Suppliers (e.g., garment manufacturers) get extended payment terms (60–90 days) to manage cash flow.
• Why it matters: Daraz’s sellers rely on this to restock inventory without immediate cash outlay.

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2. Long-Term Financing: Funding Growth and Assets

Long-term financing (≥5 years) funds permanent assets (e.g., hotel buildings, machinery). Sources:

A. Debt Financing (Loans, Bonds)

• Bank Loans: Common for hotels (e.g., Rs 50M loan at 10% for expansion).
  • Pros: Tax-deductible interest, no ownership dilution.
  • Cons: Fixed repayments increase risk.
• Bonds: Issued by large firms (e.g., NEPSE-listed hotels like Hotel Yak & Yeti).
  • Pros: Lower cost than bank loans for creditworthy firms.
  • Cons: Complex issuance process.

B. Equity Financing (Share Capital, Retained Earnings)

• Share Capital: Selling shares (e.g., Hotel Himalaya raising Rs 100M via IPO).
  • Pros: No repayment obligation.
  • Cons: Dilutes ownership/control.
• Retained Earnings: Profits reinvested (e.g., Thamel restaurants plowing back 30% of profits).

C. Leasing (Operating vs. Financial)

• Operating Lease: Short-term rental (e.g., leasing a Kathmandu event hall for 1 year).
• Financial Lease: Long-term (e.g., leasing a hotel kitchen for 10 years, treated as debt).

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D. Real-World Example: Ncell’s Debt vs. Equity

• Debt: Ncell borrows from banks for 5G infrastructure (low-cost, tax-deductible).
• Equity: Ncell’s parent (NTC) injects capital for long-term stability.

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3. Cost Comparison: Short-Term vs. Long-Term Financing

*Cost varies based on discount terms (e.g., 2/10 net 30 = ~36% annual cost).

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4. Worked Example: Kathmandu Retail Shop’s Financing

Scenario: A Thamel souvenir shop needs Rs 2M for inventory. Two options:

1. Trade Credit: Supplier offers 2/10 net 60.
2. Bank Loan: 12% p.a., 1-year term.

Step 1: Calculate Cost of Trade Credit

$$\text{Annual Cost}=\frac{2}{98}\times \frac{360}{50}=14.69\%$$ Decision: Trade credit is cheaper (14.69% vs. 12% loan), but:

• Risk: If the shop sells slowly, it may lose the discount (cost jumps to ~36%).
• Supplier Relationship: Overusing credit may hurt future deals.

Step 2: Bank Loan Alternative

• Monthly Payment: Rs 2M × (12%/12) = Rs 20,000.
• Total Cost: Rs 240,000 (interest) + Rs 2M (principal) = Rs 2.24M.
• Effective Cost: 12% p.a. (fixed, no risk of missing discounts).

Recommendation:

• Use trade credit for 60% of inventory (low-risk items).
• Take a bank loan for 40% (high-margin items).

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5. Advantages and Disadvantages

Short-Term Financing

Long-Term Financing

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6. In the Real World

1. eSewa/Khalti (Digital Payments)

   • Idea Used: Short-term financing via merchant cash advances.
   • How: eSewa advances merchants (e.g., Thamel tea shops) Rs 50,000 upfront, deducting a % of future sales (e.g., 15%). This is expensive but instant for small businesses.

2. Daraz (E-Commerce)

   • Idea Used: Trade credit for suppliers.
   • How: Daraz sellers (e.g., garment manufacturers) get 60–90 day payment terms, letting them produce inventory without immediate cash.

3. Ncell (Telecom)

   • Idea Used: Long-term debt for infrastructure.
   • How: Ncell borrows Rs 5B from banks for 5G towers, repaying over 10 years at 10% interest. The tax-deductible interest reduces their cost.

4. Hotel Industry (Kathmandu)

   • Idea Used: Leasing vs. buying equipment.
   • Example: A 3-star hotel leases kitchen appliances (operating lease) instead of buying for Rs 5M, saving upfront cash.

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7. Exam Tip

1. Memorize the discount cost formula: $$\text{Annual Cost}=\frac{\text{Discount \%}}{100-\text{Discount \%}}\times \frac{360}{\text{Net Days}-\text{Discount Days}}$$

   • Example: For 3/10 net 45, plug in values to get ~54% annual cost.

2. Compare sources in tables:

   • Examiners love pro/con lists for trade-offs (e.g., debt vs. equity).

3. Real-world applications:

   • Link answers to Nepali businesses (e.g., "Like Daraz, Hamro Hotel can use trade credit for seasonal inventory").
   • Avoid vague answers: Always quantify (e.g., "cost = 12%" not "low cost").

4. Common Pitfalls:

   • Ignoring tax benefits: Debt interest is tax-deductible (reduce cost by tax rate).
   • Mismatching terms: Short-term debt for long-term assets = liquidity risk.

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Final Note: Short-term financing is about survival; long-term is about growth. Master the cost calculations and trade-offs—this is where marks lie!