There are two sources of finance for any business; Equity and Debt. Debt financing can further be categorized as long-term and short-term financing facilities. Short-term financing is a widely used option for funding business operational activities. Many businesses struggle with delayed accounts receivable and lack of cash and look for bank financing.
Table of contents
- What is Short-Term Financing?
- Types of Short-Term Financing
- Short-Term Financing and Long-Term Financing
- Advantages of Using Short-Term Financing
- Disadvantages of Short-Term Financing
What is Short-Term Financing?
By definition, any financing or credit facility that has a repayment period of less than one year is a short-term financing facility.
The most widely used source of short term financing is bank borrowing. It remains the main short-term financing options; however there are other credit facilities that are also short-term in nature. For most businesses, working capital and operational funding remain the prime factors for short-term debts. These loans are typically unsecured and are offered without any collateral.
In terms of the interest rate charged, there are two broad categories of any type of financing.
Fixed Interest Rate Loans
As the name suggests, the interest rates remain fixed over the loan terms. Fixed-rate loans usually come with long-term maturity dates. Common examples of fixed-term loans are Bonds and Debentures, Mortgages, financial leases, and Business loans.
Floating Interest Rate Loans
Interest charged on these loans varies over the loan term often with inter-bank interest rate fluctuation such as LIBOR or the FED. Common floating interest rate loans are Revolving Credit Facilities, Credit Cards, and Mortgages.
The balanced approach for any business can be to secure long-term financing with fixed interest rates and floating rates for the short-term. Bank borrowings and private debt financing both remain critical financing sources for any business. Short-term financing may come from various sources and different terms.
Types of Short-Term Financing
Here are a few widely used Short-term financing facilities for businesses.
Revolving Credit Finance
A revolving credit financing (RCF) or a business line of credit is most commonly used form of bank borrowing with businesses. These unsecured loans come with a floating interest rate and not backed by any collateral. Banks issue an upper limit or the credit facility up to which the borrower can use the financing facility.
Characteristics of revolving credit financing:
- Borrowers pay interest on the amount withdrawn only and can be used several times within the approved maturity time without re-approvals
- These unsecured loans come with higher interest rates than fixed interest loans
- Borrowers need strong credit history as these loans are not backed up by any collateral
- Interest rate costs may rise significantly if the Central Bank rate (LIBOR) increases
Short-Term Business Loans
These borrowings come with a fixed interest rate and a short-term maturity period usually up to one year. The borrower can get an approved loan in a one lump sum amount upfront and repays the loan with fixed installments.
Characteristics of Business Loans:
- Borrowers receive the approved cash in a single Lump Sum amount
- Repayments terms with fixed interest rate are predetermined and fixed
- Total Interest costs with short-term loans remain lower than long term financing
- Provides an ideal solution to businesses struggling with delayed accounts receivables and working capital requirements
Factoring or Invoice Financing Facility
Businesses can use the outstanding invoices or accounts receivable balances as collateral to raise funds. This is called factoring accounts receivable. This option comes with private investors looking to charge higher Fees and interest on such business loans. Usually, borrowers outsource invoice balances at discount for collection at a discount of up to 90% of the total outstanding amount.
Characteristic of Invoice Factoring loans:
- Borrowers outsource accounts receivable amounts as a form of loan
- Comes with the two-way benefit of time-saving and cash benefits without compromising business relations with customers
- Third-party lenders charge high fees
- Borrowers need a strong credit history with large revenues
Operating Lease Facility
Operating leases come without owning the asset and buying costs that require large investments. Borrowers may use certain types of assets without owning them and pay monthly lease or rental amounts as agreed.
Characteristic of Operational Leases:
- The risk of asset maintenance and repairs remain with the lessor
- Flexible borrower option for a business that lacks collateral for any loan approvals
- Interest charges or rental amounts can be predetermined
- Businesses may easily renew the lease term or terminate at short notice
Commercial papers work similar in nature as Bonds but come with short-term maturity. Borrowers with strong credit history and market goodwill can issue commercial papers to raise short-term finances. These unsecured loans do not require any collateral and usually come with fixed interest rate costs. There are two widely used commercial papers. These are Euro Commercial Paper and US Commercial Paper.
Short-Term Financing and Long-Term Financing
Equity and fixed-term loans remain the prime sources for long-term financing for businesses. Both options come with certain Pros and Cons and offer different criteria to choose the right option. The first optimal target for any business should be to attain a balance in the total capital structure with equity and debt balance.
Businesses can generally use a few criteria points to decide on the short-term and long-term financing facilities.
Accessibility of Loans
Long-term loans often require an asset as collateral. Lenders also carefully examine the borrower’s credit history before loan approval. Secured loans for the long-term may not be readily available for the borrowers. Short-term loans can be secured without any collateral such as a revolving credit facility or invoice factoring.
The Financing Costs
Secured loans in general come with lower interest rates. As most long-term loans are backed by collateral, the interest rates charged will be lower. However, most long-term debts come with a higher interest rate due to longer repayment terms. Debt financing comes with a tax advantage that makes it a cheaper option than equity financing though. Short-term variable interest rate loans also come with lower interest rates.
The Duration Factor
Capital assets cannot be funded by short-term financing facilities. Similarly, any business expansion plans or large projects require financing facility over a long period. The financing approval may not remain feasible in future for any business. The duration for which the loan amount is required plays a critical role in choosing between a short-term or long-term debt options.
Businesses with a high gearing ratio may not easily have access to loan approvals. Bank borrowings in particular become increasingly difficult with high gearing ratios. The borrowers’ credit profile and credit history may also play a crucial role in the decision.
Advantages of Using Short-Term Financing
Short-term financing facilities offer a wide range of options to borrowers. Businesses looking to fund working capital requirements and improving liquidity would prefer short-term financing facilities. Below are some of the commonly known advantages of using short-term financing:
- Under normal circumstances, short-term loans come with lower interest rates
- Businesses may not require assets as collateral
- Revolving loans or line of credits can be used as flexible financing options
- Repayment terms are easier and can be altered without significant changes in the loan terms such as lease renewals
- Business receivables and invoicing can be used to secure loans without compromising customer relations
Disadvantages of Short-Term Financing
Although short-term financing offers flexible options, there are some limitations too. Below are the common short term financing problems that we typically encounter:
- Floating interest rates may increase substantially during the loan repayment terms
- Businesses may not access large capital with short-term financing facilities
- Several short-term loan facilities may prove costly for businesses such as operating leases vs. buying, invoice factoring at large discounts, etc.
Short-Term financing offers a wider pool of choices for businesses. Usually, the interest costs are lower and businesses do not require any collateral. The ideal utilization of short-term financing remains working capital management and increased liquidity.