Funding is an important activity for any business entity. Funds are required frequently for different aspects of the business. From the start up phase to running day to day operations to expansion, money is required at every step of the way. When companies are unable to generate sufficient funds from internal sources they look towards external sources of funds. One such external route for raising fund is issuing notes. A note is documented IOU in which the issuer acknowledges uptake of debt in exchange for an unconditional promise to repay the debt within a prescribed time period, as well as any attached interest.
This article looks at meaning of and differences between two types of notes based on their duration – short term and long term notes payable.
Definitions and meanings
Short term notes payable
A short-term note is a note payable that is issued with a short maturity period. Notes are generally classified as short term when the principal (and usually the attached interest) are payable within a period of less than one year.
Short term notes are generally used for funding short term obligations such as funding purchase orders, procuring raw materials and for other working capital needs.
Accounting entries in books of the issuer (borrower):
Short term notes issued for $100,000 repayable after 6 months along with 5% p.a. accrued interest. The journal entries for this issuance in borrower’s books are given below:
(i). Entry for issuance of note:
Bank a/c…..100,000 [Dr]
Notes payable*…..100,000 [Cr]
(Being notes of $100,000 with maturity of 6 months issued)
(ii). Entry for repayment of note (along with accrued interest):
Interest on notes payable a/c …..2,500 [Dr]
Notes payable a/c…..100,000 [Dr]
Bank a/c…..102,500 [Cr]
(Being interest and principal on notes issued repaid)
Issuers (i.e., borrowers) tend to prefer short term notes in an environment of reducing interest rates. This is because they can borrow funds at existing rates of interest for a short term and when interest rates reduce, they can re-borrow at lower rates.
Long term notes payable:
A long-term note is a debt instrument that is repayable over a longer time period – at least more than one year. These notes are of two broad types:
(i). Interest bearing note:
Interest bearing notes have a predetermined coupon or interest rate which is paid at predetermined intervals till maturity. An issuer of such a long term note thus undertakes to not only repay the principal back on maturity but also to pay periodic interest to the lender.
(ii). Zero-interest bearing note
Zero interest bearing notes do not have any attached coupon rate. The issuer is not obligated to pay any periodic interest but only to repay the face value of the note on maturity. These notes are generally issued at a discount to their face value. This difference between the issue price and face value repayable represents the notional interest.
As long-term notes have a higher term to maturity, they are typically opted for funding longer duration obligations. This can include purchase of capital goods and funding expansion plans etc.
Difference between short term and long term notes
The eight key points of difference between short term and long term notes are as follows:
- A short-term note is a debt instrument that is issued for a short period i.e., it is repayable by the borrower within a year of its issue.
- A long-term note is a debt instrument that is issued for a longer period i.e., it is repayable after at least more than a year.
- The duration or term to maturity of a short-term note is less than one year.
- The duration of a long-term note is more than a year – can be of 2 years, 3 years or any longer duration as agreed between the borrower and the lender.
3. Payment of interest
- In the case of a short-term note, there is a pre-determined interest rate which generally accrues and is paid along with the repayment of the principal.
- The payment of interest for a long-term note depends on whether it is interest bearing or zero interest bearing. Interest bearing notes have an attached coupon rate payable at periodic intervals. Whereas zero interest bearing notes have no pre-determined coupon rate attached to them.
- Short term notes are issued by borrowers when they wish to obtain funds for short term payment obligations – typically for working capital needs.
- Long term notes are utilized when funds are required for long term projects.
- Short term notes are generally either unsecured or secured with an overall floating charge on current assets such as inventories and accounts receivables.
- Long term notes on the other hand are likely to be secured with specific collateral such as specific property or specific machinery etc.
6. Disclosure in financial statements
- Short term notes are disclosed under the head ‘current liabilities’ on the liabilities side of the balance sheet.
- Long term notes are disclosed under the head ‘long-term liabilities’ on the liabilities side of the balance sheet.
7. Preference of borrower and lender
- Short term notes are preferred by the borrower when the market interest rates are falling. They are on the other hand preferred by the lender when the market interest rates are rising.
- Long term notes are preferred by the borrower in an environment of rising interest rates and by the lender in an environment of falling interest rates.
- Example of short-term notes are commercial papers, treasury bills, promissory notes etc.
- Long term notes are of two types – interest bearing and zero interest bearing notes.
Conclusion – short term vs long term notes
Entities generally have a mix of short-term and long-term notes in their financial statements to fund their comprehensive business requirements. As these are debt instruments, lenders need to ensure that they have assessed the credit worthiness of the borrowers before executing these notes with them. This is more so in the case of long-term notes which carry higher risk as the money is lent out for a longer duration.