Short-term Finance: Types, Disadvantages, and Advantages

Introduction

The definition of short-term finance is providing financial support to businesses from short-term sources.

Offered for a time of lower than a year, it is good helpful support. It involves producing cash by lines of credit, online loans, and invoice financing.

This generated cash helps in the operating expenses and working of the business. Short-term finance is also known as working capital financing.

It is utilized for receivables and inventory. The reason why this financing is crucial is that businesses have uneven cash flow. The various types of short-term finance are given below.

Types of Short-Term Finance

1) Trade Credit

This type is defined as the time given to businesses to pay for services and goods they have bought.

The allowed floating time is usually 28 days. The trade-credit is effective because it helps better manage the finances and the cash flow.

With trade credit, one can finance the inventories, which decide the number of days a vendor is given before the due date of payment.

The vendor offers trade credit as an inducement for the growing business. This is the reason why it is free.

2) Working Capital Loans

Most financial institutions, including banks, increase loans for a lesser period after monitoring records, the nature of the business, the working capital cycle, etc.

When a loan is sanctioned and given by the bank, it can be returned in easy installments or even be repaid once before the loan tenure period ends.

This loan tenure is established after the terms between the parties are accepted. Using the loans is wise to support the working capital requirements permanently financially.

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3) Business Line of Credit

This type of short-term finance is an effective method to fulfill working capital needs. A business must visit banks to get permission for a specific sum depending on the credit line structure.

The credit score, projected inflows, and business model judge this structure.

A maximum approved amount is also set. The business can withdraw within this maximum amount whenever required. Moreover, when the amount is available to the business, it can be deposited or repaid.

As for the interest, it is charged on the used sum according to the daily reducing balance way. In this way, the business line of credit is a very resourceful and cheap method of financing.

4) Invoice Discounting

This is defined as the arrangement of funds instead of submitting invoices. This submission depends on the payments which will be gained in the future.

The discount with third parties, banks, and any financial institution are made for the receivables invoices.

When the bills are paid, these institutions pay for the discounted value of bills. When the due date arrives, these institutions also collect the payment in the place of the business.

5) Factoring

This type is similar to invoice discounting concerning the arrangement. It is debtor finance by which the business sells the accounts receivable to a third party.

This third party can be known as the factor. It is very cheap.

The factor can be of any category, irrespective of the availability of the recourse. As for the invoice discounting, it can only be done with recourse.

Advantages of the Short Term Loans

  1. Fast disbursement: The short-term loan has a comparatively lesser risk probability than a long-term loan. This is because long-term loans have an extended maturity date. Therefore, defaulting on the loan payment in the short term is easier. Very little time is needed for the sanctioning because of the short maturity date. This is why the short-term loan is sanctioned and disbursed at a very fast rate.
  2. Less interest Expenses: Because short-term loans have to be repaid in lesser time, usually less than a year, the sum of the interest cost becomes very less. As opposed to long-term loans, they are easy. The interest rate on a long-term loan can sometimes be higher than the loan itself.
  3. Best in Class: Since the short-term loan is very less risky, not many documents will be required.
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Disadvantages of short-term finance

  1. Higher Interest Rates. Short-term finance requires higher interest rates, making it more expensive than long-term financing.
  2. Not Ideal for Long-Term Projects or Investments. Short-term financing is unsuitable for any long-term investments or projects and may not cover the labor and materials needed during a more extended period.
  3. It limited Financial Capability. With short-term financing, businesses do not have access to enough capital to cover more significant investments and transactions that occur over a more extended period.
  4. Less Flexibility with Terms and Conditions. As short-term financing usually comes from commercial lenders, they tend to impose stricter conditions compared to other types of financing, leaving little room for negotiation on the terms of repayment and interest payments.
  5. Riskier Loans. Since short-term loans are riskier than long-term loans, lenders typically require collateral before handing out the loan, meaning businesses need to put up assets as security against the loan they take out in case of default on payments later on down the line.
  6. More Documentation is Required For Loan Approval Processes. The approval process for short-term finance can be more complicated than other forms due to the additional documents that need to be submitted to prove eligibility for the loan, such as financial statements and tax returns.
  7. Poor Credit Rating May Lead To the Rejection Of Loan Requests. A business’s credit score plays a role in determining whether or not its request for short-term finance will be approved by lenders, which can lead to difficulty in getting a loan if these factors aren’t ideal.
  8. Lack Of Collateral May Prevent Loan Approval. Without collateral as security against a loan, many banks and commercial lending institutions may refuse requests for short-term finance as there is no assurance that the debt will be paid back without having some guarantee first.
  9. High Fees Associated with Short-Term Finance Options. Fees associated with traditional banking services, such as processing fees, application fees, early repayment fees, etc., can add up quickly when taking out loans from banks, making using bank loans an expensive option compared to alternative sources like peer–to–peer lending.
  10. Limited Capital Availability For Businesses With Poor Financial History Or Bad Credit Scores. Businesses with poor financial history or bad credit scores may find it difficult or even impossible to get access to sufficient capital via traditional banking services, putting them at a disadvantage when trying to implement sound business strategies which rely on some level of access to quick funding solutions like those offered by banks.
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