The Disadvantage and Advantage of Short-term Financing

Written by chirantan basu
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New and established businesses often need temporary funds to buy raw materials, meet payroll and cover temporary cash shortfalls. For example, a new restaurant might not have enough paying customers in its first few weeks and so would need financing to cover short-term bills. An established retailer might need short-term financing to stock additional items for the holiday selling season.

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Types

Short-term financing alternatives include credit cards, operating lines of credit, bank loans and trade credit. Short-term loans are usually extended on a revolving basis or for fixed terms of one year or less. Trade credit refers to deferred payment terms offered by suppliers that allow purchasers up to 30 days to settle their accounts. Other forms of financing include promissory notes, which are short-term legal I-owe-yous, and asset-backed financing in which banks advance funds using a company's inventory or accounts receivable as collateral.

Advantages

Businesses need short-term funds for several reasons. For a small business, the cash flow from sales might not be sufficient for growth funding needs, such as building new production capacity, adding new sales staff and opening new retail outlets. Companies can plug cash shortfalls or pay for emergency funding needs if they have access to operating lines of credit and other forms of short-term financing. It might be easier for businesses, especially small businesses, to secure short-term financing instead of long-term or equity financing. Short-term interest rates are lower than long-term rates, which gives management more flexibility in operating their business.

Disadvantages

Rising interest rates increase borrowing costs. Businesses that rely on variable-rate short-term loans will immediately feel the effects of rising rates. Asset-backed financing also involves different costs -- in addition to the interest rate and service fees, only a portion of the collateral pledged is advanced to the borrower. The lender might also require additional assets to be pledged as safeguards. Businesses that use credit cards for their short-term needs might see their profit margins suffer because of higher interest rates. The short-term financing might not be adequate and, for businesses that are already stretched, there might not be additional sources of funds available.

Considerations

Management must decide on the best mix of financing based on when they need the money and what types of financing are available. For example, in a falling interest rate environment, management might want to lock in long-term rates at favourable terms or renegotiate their existing short-term borrowing. By employing cash management strategies, such as cutting back on expenses or being more aggressive on the collection of accounts receivable, businesses can reduce their financing requirements.

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