Short-Term Debt

Debt obligations that are due to be paid either within the next 12-month period or the current fiscal year of a business.

What is Short-Term Debt?

Short-term debt is defined as debt obligations that are due to be paid either within the next 12-month period or the current fiscal year of a business. Short-term debts are also referred to as current liabilities. They can be seen in the liabilities portion of a company’s balance sheet.

Short-Term Debt

Short-term debt is contrasted with long-term debt, which refers to debt obligations that are due more than 12 months in the future.

Short-term debt is most commonly discussed in reference to business debt obligations but can also be applied in the context of personal financial obligations.

Understanding Short-Term Debt

There are usually two types of debt, or liabilities, that a company accrues—financing and operating. The former is the result of actions undertaken to raise funding to grow the business, while the latter is the byproduct of obligations arising from normal business operations.

Financing debt is normally considered to be long-term debt in that it is has a maturity date longer than 12 months and is usually listed after the current liabilities portion in the total liabilities section of the balance sheet.

Operating debt arises from the primary activities that are required to run a business, such as accounts payable, and is expected to be resolved within 12 months, or within the current operating cycle, of its accrual. This is known as short-term debt and is usually made up of short-term bank loans taken out, or commercial paper issued, by a company.

The value of the short-term debt account is very important when determining a company's performance. Simply put, the higher the debt to equity ratio, the greater the concern about company liquidity. If the account is larger than the company's cash and cash equivalents, this suggests that the company may be in poor financial health and does not have enough cash to pay off its impending obligations.

The most common measure of short-term liquidity is the quick ratio which is integral in determining a company's credit rating that ultimately affects that company's ability to procure financing.

Quick ratio = (current assets - inventory) / current liabilities

KEY TAKEAWAYS

Short-term debt, also called current liabilities, is a firm's financial obligations that are expected to be paid off within a year.
Common types of short-term debt include short-term bank loans, accounts payable, wages, lease payments, and income taxes payable.
The most common measure of short-term liquidity is the quick ratio which is integral in determining a company's credit rating.

Types of Short-Term Debt

The first, and often the most common, type of short-term debt is a company's short-term bank loans. These types of loans arise on a business's balance sheet when the company needs quick financing in order to fund working capital needs. It's also known as a "bank plug," because a short-term loan is often used to fill a gap between longer financing options.

Another common type of short-term debt is a company's accounts payable. This liabilities account is used to track all outstanding payments due to outside vendors and stakeholders. If a company purchases a piece of machinery for $10,000 on short-term credit, to be paid within 30 days, the $10,000 is categorized among accounts payable.

Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories, and meeting short-term liabilities such as payroll. Maturities on commercial paper rarely range longer than 270 days. Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates, and is useful because these liabilities do not need to be registered with the SEC.

Sometimes, depending on the way in which employers pay their employees, salaries and wages may be considered short-term debt. If, for example, an employee is paid on the 15th of the month for work performed in the previous period, it would create a short-term debt account for the owed wages, until they are paid on the 15th.

Lease payments can also sometimes be booked as short-term debt. Most leases are considered long-term debt, but there are leases that are expected to be paid off within one year. If a company, for example, signs a six-month lease on an office space, it would be considered short-term debt.

Finally, taxes are sometimes categorized as short-term debt. If a company owes quarterly taxes that have yet to be paid, it could be considered a short-term liability and be categorized as short-term debt.

Types of Debt

The debt obligations of a company are commonly divided into two categories – financing debt and operating debt.

Financing debt refers to debt obligations that arise from a company borrowing money to fund the expansion of its business. An example of financing debt may be taking out a large bank loan or issuing bonds to fund a major capital expenditure, such as the construction of a new plant.

Financing debt is typically long-term debt since the amount of debt incurred is usually too large for a company to be able to reasonably repay in full within one year.

Short-term debt more commonly consists of operating debt, incurred during a company’s ordinary business operations.

The most common example of short-term debt is a company’s accounts payable, which is the money it owes to suppliers or providers of services the company uses, and that is usually expected to be paid off within the very near term.

Examples of Short-Term Debt

Short-term debt may exist in several different forms. Some of the most common examples of short-term debt include:

Accounts Payable – Accounts payable includes all the money a company owes through ordinary credit purchases from suppliers, such as purchases from wholesalers to stock its products. It also includes monthly bills, such as utility bills and office rent.
Short-Term Loans – A company often needs to take out a short-term loan from a bank or other lending institution to help it bridge a cash flow problem. If a company is having trouble collecting its accounts receivable, that can make it difficult to cover its accounts payable. The company may take out a short-term loan, such as a 90-day note, which is due to be repaid within three months.
Commercial Paper – Instead of taking out a bank loan, some companies choose to issue commercial paper – unsecured promissory notes that typically come due in nine months or less.
Lease Payments – It’s common for many companies to lease, rather than purchase, The payments on such leases that are due within the next 12 months are a component of the company’s short-term debt.
Taxes Due – The tax component of short-term debt includes any local, state, federal, or other types of taxes that a company may owe that are due to be paid within the current year.
Salaries and Wages – All salaries due to be paid to employees within the current year are also considered part of short-term debt.
Stock Dividends – If a company has declared, but not yet paid, stock dividends to its shareholders, the dividends are part of the company’s short-term debt.

Assessing a Company’s Debt

Financial analysts typically use several financial metrics to examine a company’s debt liability to determine how financially sound the company is. Two commonly used ratios that focus on a company’s short-term debt obligations are the current ratio and the working capital ratio.

Current ratio is calculated as the company’s current assets divided by its current liabilities. It indicates the company’s ability to meet its short-term debt obligations with relatively liquid assets.

A current ratio of 1.0 indicates that the company’s liquid assets roughly match its current liabilities. A ratio higher than 1.0 indicates that its current assets are more than sufficient to meet its current debt obligations.

Working capital ratio is the sum of current assets minus current liabilities. Any positive number indicates that a company holds excess capital beyond that which is required to pay off its short-term debt.

How to Pay Off Short-Term Debt

There can be a few ways to pay off short-term debt, but before you get started it’s always important to know your borrowing limit to better manage your debt load. In the case of a company’s short-term debt, they will likely have a payoff strategy in place that would come through generating additional revenue.

In the case of personal short-term debt obligations, earning extra income, reworking your budget, and categorizing debts can all help you pay off short-term debt.

What Are the Pros and Cons of Short-Term Debt?

One of the best ways to gain quick access to new capital is to take on short-term debt. This can help fund things like equipment, labor, and supplies. There are a few things worth highlighting when it comes to the pros and cons of short-term debt. Let’s take a closer look.

Pros of Short Term Debt

There is often relaxed eligibility requirements from short-term lenders
You can get approved for short-term debt in as little as a few days or less
Payment plans allow you to pay off debt fast, with plans no longer than 18-months

Cons of Short-Term Debt

You’re offered higher interest rates compared to other types of debt
There becomes a high-cycle risk if you can’t make payments on time
You might end up spending more compared to a lower-cost term loan from somewhere else

Summary

The short-term debt relates to any portion of total debts that a company needs to pay off. And these must happen within the next 12 months or within the individual company’s current fiscal year. Short-term debt is defined as the portion of a company’s total debts that are due to be paid within either the next 12 months or within the company’s current fiscal year.

Short-term debt is separated from long-term debt, which consists of debt obligations a company has whose repayment period extends more than 12 months into the future.

With long-term debts, these are debts that are due when the repayment period extends past 12 months into the future. Some of the most common examples of short-term debt include short-term loans, wages due to employees, lease payments, current taxes due, and salaries.

Common examples of short-term debt include accounts payable, current taxes due for payment, short-term loans, salaries, and wages due to employees, and lease payments.