A company has two primary sources of finance, Debt, and Equity. We typically divide the debt financing into the long-term and short-term financing categories. Companies often use Short-term debts for operating needs such as working capital management and accounts payables.
What Is Unsecured Short-Term Financing?
We can define any financing options under the unsecured and short-term financing category as:
- A debt not backed by collateral such as a company asset
- Debt with a maturity date within 12 months
Short-term financing comes with a higher risk for lenders and hence they charge higher interest rates and processing fees. Companies with limited tangible assets or higher leverage often have to use unsecured loans for the short-term.
Characteristics of Unsecured Short-Term Financing
Even though unsecured loans are not backed by collateral, yet they offer some value to both lenders and the borrowers. Both parties retain some benefits that make it possible to proceed with an unsecured type of short-term loan.
The main characteristics of unsecured short-term financing are:
- Lenders do not require any collateral other than the borrower’s creditworthiness
- These loans come with high-interest rates and transaction fees
- Borrowers can access these funds quickly
- These loans come with short maturity of fewer than 12 months
Sources of Unsecured Short-Term Financing
Borrowers can acquire unsecured loans from banks, financial institutes, and private lenders. The nature of these loans without the collateral and higher interest rates remains the same for most of the lenders.
The sources of unsecured short-term financing that we commonly see are as follows:
Revolving Credit Facilities and Bank Loans
In this facility, the bank approves a maximum limit of loan for the borrower. The borrower can withdraw money up to the upper limit of the loan and can deposit to regain the loan limit. The banks charge interest on the withdrawn amounts only. The facility works like a credit card facility for an individual.
This type of unsecured source of short-term financing provides a company with a flexible financing option. Usually, banks approve the RCF for a maturity period of 12 months but can renew the facility on an on-going basis.
Bank Overdraft Facility
A bank Overdraft works as an extension facility rather than a separate financing option. The overdraft facility also comes with a similar working contract as the loans. The bank approves a certain upper limit and charges transaction fees and interest for the facility. As the company does not require any collateral, and the facility is usually linked with the company corporate account, it best serves as a short-term unsecured bank financing option.
Commercial Papers
Commercial papers are unsecured financial instruments that large companies may issue in the money markets. The commercial papers work similarly to the Corporate Bonds but unsecured without collateral. Large companies issue these commercial papers to settle the inter-bank payments and interests. These commercial papers come with a maturity period of up to 09 months.
One of the main advantages of commercial papers is that these financial instruments can also be traded on financial markets, similar to corporate bonds. The issuers offer a discount on the face value of the commercial papers to attract investors and make them tradable securities on the market.
Money Market Borrowings
Large corporations use the money market borrowings terminology for lending amounts to each other. Often financial institutes need to settle the interest and currency futures and borrow these funds for the short-term. These borrowings usually work on the maturity of a single day to a few weeks only.
Operating Leases
A company may acquire an asset or machinery on an operating lease basis. The operating lease does not shift the ownership of the asset. Companies requiring high-cost machinery or technology equipment often consider operating leases. It is not a direct form of loans. It serves as an alternative short-term financing option for the company.
Note: Operating Leases are the only unsecured and short-term financing options. Under a financial lease or a sale and leaseback option, the ownership and terms change.
Private Lenders
Private lending platforms and individuals lend money to the businesses for the short-term. These loans usually take shape of a peer-to-peer lending contract. These are also unsecured loans that do not require any collateral. These loans also come with very high-interest rates. The interest rate charged by private lenders is usually manifolded higher than bank RCF or short-term loans.
Merchant Cash Advances
Businesses with credit card processing and POS sales can acquire this facility. A merchant cash advance works more like a trade advance rather than a loan. The card processing companies or banks can offer short-term loans against the credit card payment records they hold.
Advantages of Unsecured Sources of Short-Term Financing
For Lenders of Unsecured Loans:
- The unsecured loans offer high-interest rates and loan processing fees
- They retain customer loyalty
- The loan processing is faster and backed by the borrower’s creditworthiness
- The lenders can move the lien in case of the default
For Borrowers of Unsecured Loans:
- Borrowers do not have to pledge any assets as collateral
- The loan processing is fast
- They can utilize the facility to fund the operational or other business needs without any covenants attached by the lenders
- Can be used as a revolving credit facility
Lack of access to the financing options and higher cost of equity are the main drivers behind the unsecured debt financing. For large companies with high creditworthiness, it almost comes as a readily available option. Banks and other financial institutes have the opportunity of earning higher interest rates as well as accommodating worthy customers.
Disadvantages of Unsecured Loans
Unsecured loans possess risks for both the borrowers and the lenders:
- Lenders may not be able to recover the full repayment in case of borrower’s default
- Both lenders and borrowers may end up settling the loans with litigation
- Borrowers pay very high-interest rates and transaction fees with unsecured loans
- Lenders may not approve large loan amounts with unsecured loans
Conclusion
Most of the short-term financing takes place as unsecured loans. The borrower’s creditworthiness plays an important role in the approval of these loans. However, the borrowing costs and charges along with repercussions can be high for the borrowers.
