What is Short-Term Debt?

Short term debt, also called current liabilities, is a firm's financial obligations that are expected to be paid off within a year. It is listed under the current liabilities portion of the total liabilities section of a company's balance sheet.

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VIDEO: What's Short-Term Debt?

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 that is 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 employees are paid by their employers, 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 he or she is 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.