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What Is Short-Term Debt?
By Belinda Estes MONEY RESEARCH COLLECTIVE
Businesses may have short-term and long-term debt to finance different areas of the company. You typically have to repay short-term debt within a year. It can include money you owe for wages, accounts payable, short-term loans and more. Additionally, a long-term loan may be broken down into short- and long-term debt. The short-term debt is what you owe within a year (current liabilities).
This guide will cover what short-term debt is and show you how to calculate it. We’ll also discuss common types of debt, including long-term, financing and operating debt. Read on to learn more about short-term debt to improve financial decision-making for your business.
Short-term debt explained
Short-term debt, also called current liabilities, is a loan or combination of loans with a short maturity date or repayment deadline. Usually, the entire balance and any interest accrued are due within a year or less.
Because they are short-term, these loans are typically smaller and meant to help businesses meet their immediate responsibilities. Businesses usually take on short-term debt to deal with immediate cash flow problems that could cause missed payments, production or service delivery disruptions and other operational issues.
How short-term debt is recorded
Businesses list short-term debt on a balance sheet as current liabilities. Your company’s balance sheet is an important financial document with information about your business’s liabilities, assets and capital. You should regularly review your balance sheet to monitor and assess your business’s financial strength.
Current liabilities represent all of a business’s current financial responsibilities for the operating cycle and may include the following:
- Short-term loans
- Inventory
- Services
- Lease or rental payments
- Wages and salaries
- Long-term debt payments (for the current period only)
The total value of your current liabilities helps you determine how heavy your debts are compared to your income and assets.
How is short-term debt different from long-term debt?
The main difference between short-term and long-term debt is the maturity dates of each one. Your lender will typically expect you to pay off short-term debts within the current operating cycle. In comparison, anything that’s expected to take over a year to pay off completely is considered long-term debt. As a result, the amount of money you borrow for short-term debt tends to be smaller than long-term debt amounts.
However, your loan may be broken down into long-term and short-term debt. The short-term debt is what you’re required to pay from the full loan within 12 months. The long-term debt is what you owe in the future. As you pay the loan, you’ll owe a portion of the debt each period until it’s paid off.
What is short-term liquidity?
Short-term liquidity is a ratio that measures your current liabilities and current assets. In other words, it shows whether you have the cash to finance your short-term debt payments. This ratio often indicates whether you can meet your short-term financial responsibilities.
Examples of short-term debt
There are several types of short-term debt. Here are some key examples, which we explore in detail below:
- Short-term bank loans
- Invoice financing
- Bank overdraft
- Accounts payable
- Commercial paper
- Salaries and wages
- Lease payments
- Stock dividends
- Lines of credit
- Taxes due
Short-term bank loans
The most common type of short-term debt comes in the form of bank loans. Companies may use short-term bank loans to help with cash flow problems or other emergencies. For example, if a company has issues securing its accounts receivable, a short-term bank loan can bridge the gap to cover its accounts payable. These loans are most commonly due to be repaid in less than a year.
Invoice financing
Invoice financing is a type of cash advance companies get from using their invoices as collateral. More specifically, it’s when a company borrows capital on its accounts receivable or unpaid invoices of its customers.
With invoice financing, you find a lender — typically an invoice financing company — that will provide you with a cash advance based on a portion of your customers’ unpaid invoices. The lender then charges you interest based on how long it will take for your customers to pay them off in full.
While this may be a way for companies to get cash quickly, it typically involves high fees and interest rates. It’s also risky, as you rely on your customers to pay on time. If they don’t, you may end up paying additional fees.
Bank overdraft
A bank overdraft is essentially a short-term bank loan that covers the cost of purchases that exceed what the company has available in its account. This type of debt usually has much higher interest rates than other forms of short-term debt. But the actual interest rate will vary depending on the bank and the type of account.
Accounts payable
Accounts payable is money owed to a company’s suppliers for products or services purchased on credit. This can be from wholesalers to stock products or monthly bills such as:
- Utility bills
- Office rent
- Internet bills
- Cleaning services
- Office supplies
- Subscriptions and software
Commercial paper
Commercial paper is a promissory note that’s short-term and unsecured. Corporations may issue commercial paper investments to avoid taking out a bank loan. They may use them to finance payroll, accounts payable, inventories and other short-term liabilities. The minimum denomination is $100,000 and it’s usually due within nine months or less.
Salaries and wages
Salaries and wages are payroll debts owed to the company’s employees. This is the amount a company will pay employees within the next 12 months.
Lease payments
Many companies lease their offices or equipment rather than purchasing them outright. These lease payments are typically due monthly. The total due during 12 months is considered short-term debt.
Stock dividends
Stock dividends are payments that are due to shareholders. Once shareholders are notified of their dividend payments, the company usually pays these within one year.
Stock dividends are typically paid in either cash or more shares. For example, if the company issues a stock dividend of 3% to be paid in shares, it will pay .03 shares for every share a stockholder has. If a stockholder owns 100 shares, they would receive three additional shares.
Lines of credit
Banks may issue a revolving credit line to businesses. The loan terms are usually six to 12 months, and companies can access these funds anytime they need capital. Once the balance is paid with any interest accrued, the credit line’s total amount is available whenever needed.
Taxes due
Any local, state or federal taxes due within the next 12 months or the current operating cycle are considered a short-term liability.
How to calculate short-term debt
Calculating short-term debt is essential to keeping debt in check and determining the liquidity of the company’s finances. It’s also a big part of calculating a company’s credit rating.
To calculate it, you need to add up all current liabilities. You can then use this figure to calculate several ratios that can help determine your overall financial standing. We go through the most important debt ratios below.
Debt-to-equity ratio
You can use your debt-to-equity (D/E) ratio to evaluate your financial leverage. To calculate it, divide your total liabilities by your shareholder equity. The lower this ratio is, the better off your company is financially.
A ratio of 2.0 or lower is considered an optimal level. A ratio of 2.0 means that a company gets two-thirds of its debt from financing and one-third from equity.
Current ratio
Your current ratio indicates your company’s ability to meet its short-term debt obligations. To calculate the current ratio, divide your current assets (what you expect to receive as cash in one year) by your current liabilities (what you must pay in one year).
A ratio of 1.0 means your liquid assets are sufficient to cover your short-term obligations. Ratios that are lower than 1.0 could mean the company is not able to pay its short-term liabilities.
Working capital ratio
Your working capital ratio will indicate your ability to meet your upcoming financial responsibilities. This ratio is calculated by taking your current assets and subtracting your current liabilities.
If the number is negative, your debt outweighs your current assets and can indicate your business is in a financial deficit. A positive number indicates your current liquidity is more than your current liabilities.
Advantages of short-term debt financing
There are several advantages of using short-term debt funding rather than long-term funding. For one, the underwriting process for short-term loans is almost always shorter than for long-term loans, meaning the funds are available sooner. Short-term debt financing may be your better option if you need cash immediately.
Similarly, because short-term loans are meant to be borrowed for a short amount of time, it’s usually much easier to meet the requirements for these types of loans. For instance, it’s easier for small businesses with low credit scores to receive short-term rather than long-term funding.
Short-term liabilities are usually unsecured, meaning they don’t require any assets to use as collateral.
Stay on top of your debt
While short-term debt can help you meet your immediate responsibilities, keeping your liabilities in check is essential. If your business isn’t meeting cash flow expectations, short-term debt may not be the best option for you.
Use your balance sheet and financial ratios to determine if you should add more short-term debt or consider long-term debt solutions. If you have more liabilities than assets, it may be better to consider alternative financing options.
If you find your company struggling with debt, there are a few ways to help get it back under control. First, you can try to negotiate your debt. This usually means you and the debt collector agree on terms to pay off your debt, including reducing the amounts you owe. Collection agencies buy outstanding debt for pennies on the dollar of what you owe. Often, they are willing to accept a reduced amount to settle the debt. They may also agree to a payment plan with lower monthly payments than the original creditor.
You may also consider consolidating your debt. This method combines all of your loans and other debts into one monthly payment. Since the new combined loan will only have one interest rate, rather than several for each loan, you will likely pay less interest. This may help you pay off your debt faster.
If you have already let your debt get out of control, you may need to repair your bad credit before getting more loans or other forms of borrowed capital. You’ll likely have to speak with a debt collector in this case. Learning how to deal with debt collectors can help get the best deal possible on paying off your debt.