Long Term Financing Definition
Long Term Financing is a type of borrowing that is expected to be fully paid over one year period. Such long term financing sources can be domestic or international markets via non-convertible debentures, term loans, bonds or private equity routes.
- The fundamental principle of long term finances is to finance the strategic capital projects of the company or to expand the business operations of the company.
- These funds are normally used for investing in projects that are going to generate synergies for the company in the future years.
- Eg: – A 10-year mortgage or a 20-year lease.
Sources of Long Term Financing
#1 – Equity Capital
It represents the interest-free perpetual capital of the company raised by public or private routes. Either the company may raise funds from the market via IPO or may opt for a private investor to take a substantial amount of stake in the company.
- In equity financing, there is a dilution in the ownership and the controlling stake rest with the largest equity holder.
- The equity holders have no preferential right in the dividend of the company and carries the higher risk across all the buckets.
- The rate of return expected by the equity shareholders is higher than the debt holders due to the excessive risk they bear in terms of repayment of their invested capital.
#2 – Preference Capital
Preference shareholders are those who carry preferential rights over equity shareholders in terms of receiving dividends at a fixed rate and getting back the invested capital in the company in case if the same is wound up.
- It is a part of the Net Worth of the Company thus increasing the creditworthiness and improving the leverage as compared to the peers.
#3 – Debentures
Is a loan taken from the public by issuing debenture certificates under the common seal of the company? debentures can be placed via public or private placement. If a company wants to raise money via NCD from the general public, it takes the debt IPO route where all the public subscribing to it gets allotted certificates and are creditors of the company. If a company wants to raise money privately, It may approach the major debt investors in the market and borrow from them at higher Interest Rates.
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- They are entitled to a fixed payment of interest as per the agreed upon terms mentioned In the term sheet.
- They do not carry voting rights and are secured against the assets of the company.
- In case of any default in payment of debenture interest, the debenture holders can sell the assets of the company and recover their dues.
- They can be redeemable, irredeemable, convertible and non-convertible.
#4 – Term Loans
They are given generally by banks or financial institutions for more than one year. They have mostly secured loans given by banks against strong collaterals provided by the company in the form of land & bldg, machinery, and other fixed assets.
- They are a flexible Source of finance provided by the banks to meet the long term capital needs of the organization.
- They carry a fixed rate of interest and gives the borrower the flexibility to structure the repayment schedule over the tenure of the loan based upon the cash flows of the company.
- It is faster as compared to the issue of equity or preference shares in the company as there are fewer regulations to abide and less complexity.
#5 – Retained Earnings
These are the profits that are been kept aside by the company over a period of time to meet the future capital needs of the company.
- These are free reserves of the company which carries nil cost and are available free of cost without any interest repayment burden.
- It can be safely used for business expansion and growth without taking additional debt burden and diluting further equity in the business to an outside investor.
- They form part of the net worth and have an impact directly on the equity share valuation.
Examples of Long Term Financing Sources
1) Funds raised by an NBFC named Neo Growth Credit Private Limited via private equity routes from LeapFrog Investments amounting to Rs 300 Crores (~43 Million Dollars)
2) Amazon raised $54million via IPO route to meet the long term funding needs of the company in 1997.
3) Apple raises $6.5 billion in debt via bonds
4) Paytm to raise funds via selling a significant controlling stake in the company to Warren Buffet for $10-$12 billion.
Advantages of Long Term Financing
- Align specifically to the long term capital objectives of the company
- effectively manages the Asset-Liability position of the organization
- Provides long term support to the investor and the company for building synergies.
- Opportunity for equity investors to take controlling ownership in the company.
- Flexible repayment mechanism
- Debt diversification
- Growth & expansion
Limitations of Long Term Financing
- Strict regulations laid down by the regulators for repayment of interest and principal amount.
- High gearing on the company which may affect the valuations and future fundraise
- Stringent provisions under the IBC Code for non-repayment of the debt obligations which may lead to bankruptcy.
- Monitoring the financial covenants in the term sheet is very difficult.
Important Points to Note
- The management of the company needs to be assured about creating a mix in the short term and long term financing sources of the organization as more long term funds may not be beneficial for the company as it affects the ALM position significantly.
- The credit rating of the company also plays a major role in raising funds via a long term or short term means. hence improving the credit rating of the company might help the organizations to raise the long term funds at a much cheaper rate.
This has been a guide to long term financing definition. Here we discuss the top 5 sources of long term financing along with examples, advantages, and disadvantages. You can learn more about excel modeling from the following articles –