Small and medium-sized businesses often struggle to cope with lower liquidity. Cash crunch proves a tangling problem than profitability. Delayed accounts receivables and uncertain economic conditions affect the cash flows for small businesses in particular. Small businesses funded with a limited contributed capital cannot raise financing from capital markets such as stock or bond markets. The only realistic option remains the bank or money market borrowings. Long-term financing with fixed interest rates is a secured loan that requires tangible assets as collateral.
In this article, we cover the short-term financing options for small business. Let’s go through together.
Table of contents
- What is Short-Term Financing?
- Why Small Business Needs to Finance?
- Short-Term Financing Options for Small businesses
- Factors to Consider Before Financing
- The Bottom Line
What is Short-Term Financing?
In practice, any credit facility that lenders offer to the borrowers against an interest charged can be termed as short-term financing. Bank borrowings and money market loans remain the widely used debt facilitators. However, for small businesses short-term financing may also include pay-day loans, extended wages period, deferred tax payments, etc.
Small businesses face the dilemma of balancing trade relations between suppliers (payables) and customers (receivables). Cash shortage remains the prime necessity with short-term financing.
Why Small Business Needs to Finance?
There are some common reasons for small business’s needs for short-term financing. These are as follow:
Working Capital Management
Pressurizing customers for payments can incur a loss of trade relationships and lower discounts. Short-term debts like a revolving credit facility can ease the pressure off from the small business owners. Borrowers can obtain these loans without collateral and increase the cash liquidity for working capital management.
Inventory purchases for raw material, payments for overheads, and indirect labor costs also remain important motive for short-term debt facility. As with receivables, businesses face crunch terms from suppliers and need inventory payments on time. Small businesses look for short-term debts for closing the trade gap of working capital between receivables and payables.
Large business expansions require fixed term and large capital requirements. However, small businesses may need short-term loans for business restructuring and small expansion projects. Securing a loan for expansions is relatively easier as business with profit-generating and higher sales ability will look for expansion. Lenders consider such financing safe and offer lower interest rates.
Machinery and Operating Tools
Refurbishing and replacing expensive machinery may prove at times costly. Lack of cash and funds may compel businesses to fund the machinery and tools purchasing with financing facilities. Some businesses also look for converting operating machinery leases to buying contracts and need to make the final settlements.
Tax and Payroll Payments
Deferred taxes and delayed payroll expenses may accrue large business penalties. Some recession hit business may not find enough cash cushion to make payroll and tax obligations on time. A small revolving facility may fulfill the payroll obligation needs.
In addition to funding these operational and financing needs, a business may need to restructure and refinance. Debt consolidation and debt refinancing can also result in a large short-term financing facility for small businesses.
Short-Term Financing Options for Small businesses
Small businesses lack valuable and tangible large assets to pledge as collateral. Lack of collateral often compels them to look for unsecured and short-term trade loans. Realistically, unsecured loans remain the only choice for small businesses. However, a small business with good credit history and strong brand goodwill can also avail secure loans. Traditional financing options may include bank borrowings, business credit cards, and invoice factoring. Below are the short-term financing options for small businesses that are available:
Short-Term Bank Borrowings
Bank borrowings remain the most widely used financing options for all businesses. Banks do not require collateral for such facilities, but often analyze borrower’s credit history and business goodwill before approving the facility. Commonly used bank borrowing financial instruments can be listed as:
- Business Line of Credit: A Line of credit or revolving credit facility comes with a floating interest rate option. The business can utilize the facility before the maturity date and pays interest on the amount withdrawn only.
- Business Loans: These business loans come with a fixed interest rate. The benefit for the borrowers is to receive the loan amount upfront in a lump sum form. Interest charged for fixed interest loans is usually higher than floating interest rates.
- Business Credit Cards: Much like personal cards, business credit cards are a form of unsecured and floating interest rate debt. The interest rates charged are significantly higher than other loans.
A Small business may also get trade loans in the form of cash advances from merchant partners. Delaying accounts payable and shortening accounts receivable may also work as a trade loan facility. These advances work well for established businesses having reliable trade relationships. Another way of securing a trade loan is invoice factoring that comes with a third-party arrangement. However, small businesses do not have significant invoice balances to pledge as collateral or make investors interested.
Operating Lease, and sale and leaseback borrowings
Operating leases for small machinery and equipment remains a favorable option for small businesses. The ownership of asset remains with the lessor along with major maintenance costs.
If the business has an asset with useful remaining life, it may use the sale and leaseback from a lender. This option works well for small businesses looking for some cash and lacking assets as collateral. The risk with the option is the forfeit of the underlying asset by the lease term maturity.
Alternative Sources of Financing
Most lenders look for some sort of security before lending the money, e.g. a tangible asset, credit history, business Goodwill, etc. The dilemma for small businesses remains the lack of collateral and financial security though. Economic recessions and financial contingencies make borrowings even harder. Alternative funding options can provide vital support in financial crunch times for small business owners.
Peer-to-Peer Lending Platforms
These are private lending clubs that offer short-term unsecured loans to individuals and businesses. These lenders usually charge higher commission and fees than banks but offer easy access to cash with unsecured loans.
Government institutes offer research and development grants to individuals and businesses. These grants can help sustain the research work for a business in relevant categories. Also, governments provide valuable financing facilities with one-time aid and relief packages.
Under economic recessions, deferred taxes and relaxed bank repayment schedules also work as short-term financing options.
Small business owners may also use personal loans for business purposes. A Home Equity loan secured against the borrower’s house as collateral may work as financing facility for the business owner. Remember, first mortgages or other personal loans may not be used for business purposes.
Factors to Consider Before Financing
Debt and equity remain the two prime funding sources for any business. Each option comes with certain benefits and risks. For small businesses, the foreclosure and asset seizure may result in irrevocable losses. Although financing is cheaper with some tax advantages but often comes with strict covenants.
Debt financing in general offers some advantages over equity financing as:
- Small business owners’ lack equity financing, debt financing from banks can offer reliable source of funding
- Debt financing costs can bring tax benefits unlike equity financing
- Business line of credits and revolving credits come with lower interest rates
- Small businesses may use informal alternative financing with lower costs
- Short-term financing facilities do not require collateral usually considered an obstacle for debt financing
- Debt financing does not incur any loss of control over business as long as debt terms and conditions are satisfied
Some important risk factors to consider with financing options:
- Regular interest payments increase the business costs and reduce monthly cash surplus
- Small businesses with unlimited liability may face the risk of property or asset seizure with loan defaults
- Higher gearing with more debts increases the borrowing costs significantly
- Private lenders may charge higher fees or commission for unsecured loans such as payday loans and peer-to-peer lending options
- Floating interest rate loans are exposed to interest rate risks as the FEDERAL or LIBOR rates often change with economic conditions
The Bottom Line
Debt financing remains a realistic source of finance for small businesses. Short-term financing obtained with caution and properly managed can offer cash flexibility. Lack of short-term financing can result in loss of trade relationships and lower sales revenue.