Business loans are generally classified as either short-term or long-term loans. For short-term loans, the principal (the amount borrowed) must be repaid within one year. Long-term loans mature (come due) in more than a year. Creditors, people who make loans, expect to receive interest (payments for the use of their money) and the return of the principal at the end of a specific period of time. Interest is expressed as a percentage of the principal.
Short-term Financing. Short-term loans are used to finance the everyday costs of doing business, such as payrolls, raw materials, and merchandise. The most common types of short-term financing are trade credit, loans from financial institutions, and loans from investors.
• Trade credit works like a department store charge account. Customers charge purchases to their accounts for payment at a later date. But here the customers are businesses whose suppliers allow them to charge purchases of materials and other items for later payment.
• Loans from financial institutions, such as banks and finance companies, are another source of short-term credit.
• Finally, some of the nation's largest businesses can obtain loans from investors to meet their short-term financial needs. If, for example, General Motors needed $10 million to finance a payroll, it could raise the money by selling commercial paper- a kind of IOU issued by a corporation, promising to repay a sum of money at a specified rate of interest. Investors wishing to earn interest on their surplus funds can buy these lOUs from brokers specializing in such investments.
Long-term Financing. Long-term financing is money that will be used for a year or more. Building a factory, purchasing equipment, and launching a major research effort are projects that require long-term financing. Why would anyone lend money to a business for a year or more? Because revenues from these kinds of projects (like a new factory) continue to flow for a long period of time. This makes it possible for borrowers to repay their loans as promised. Common sources of long-term financing are retained earnings, long-term loans, and the sale of stock.
Retained earnings are undistributed profits. Corporations can do one of two things with their profits: distribute them to their shareholders in the form of dividends, or retain them and plow them back into the business. Sometimes these retained earnings are used to finance major projects.
Long-term loans are repaid over more than one year. The most common form of long-term loan is the mortgage, a loan secured by real estate (land or buildings). If the borrower fails to make payments on the mortgage, the lender may take the property. Families who own a home or apartment probably have a mortgage on the property. Many large corporations raise long-term capital through the sale of bonds. Corporate bonds are a kind of IOU sold to the general public, usually in amounts of $1,000. The corporation promises to repay the face value of the bond at a specific time. In addition, the bondholder receives interest according to a schedule - usually twice a year. Because the money paid for a bond is really a loan, bondholders are considered creditors of a corporation. This means the corporation legally must pay bondholders interest and principal when it is due.