Short Term Financing Definition
Short term finance refers to the type of financing which aims for a smaller period which is generally less than a year. It is also referred to as working capital financing and is used for inventory, receivables, etc. In most cases, this type of financing is required in the business process because of their uneven cash flow into the business or due to their seasonal business cycle.
Types of Short Term Financing
Below are the types of Short Term Financing
#1 – Trade Credit
This is the floating time allowed the business to pay for the goods or services which they have purchased or received. The general floating time allowed to pay is 28 days. This helps the businesses in managing their cash flows more efficiently and help in dealing with their finances. Trade credit is a good way of financing the inventories which means how many numbers of days the vendor will be allowed before its payment is due. The trade credit is offered by the vendor as an inducement in continuing business and that is why it costs nothing.
#2 – Working Capital Loans
Banks or other financial institutions extend loans for a shorter period after studying the business nature, its working capital cycle, past records, etc. Once the loan is sanctioned and disbursed by the bank or other financial institutions it can be repaid in small installments or can be paid in full at the end of loan tenure depending on the agreed terms of loans between both the parties. It is often advised to finance the permanent working capital needs through these loans
#3 – Invoice Discounting
It refers to arranging the funds against the submission of invoices whose payments are to be received in the near future. The receivables invoices are discounted with the banks, financial institutions or with any third party. On submission of bills, they will pay the discounted value of bills and on the due date, they on the business behalf will collect the payment.
#4 – Factoring
It is a similar arrangement of finance like invoice discounting. It is debtor finance in which business sells their accounts receivable to a third party whom we call factor at a rate which is lower than the net realizable value. It can be of any type with recourse or without recourse unlike invoice discounting which can only be with recourse.
#5 – Business Line of Credit
It is the best way of financing working capital needs. The business can approach the bank for approval of certain amount based on their credit line structure judged through a credit score, a model of business, projected inflows. The business can withdraw the amount as and when needed subject to the maximum approved amount. They can again deposit the amount as and when it gets available. Moreover, the best thing is that interest is charged on the utilized amount on daily reducing balance method. In this manner, it becomes very cost efficient mode of financing.
Example of Short Term Finance
Marry took the loan of $10,000 for the period of 6 months at the 5% APR. Since the loan is for the shorter period i.e. the period of less than one year, it will be treated as the short term finance. After the 6 months marry has to repay the loan amount along with the interest due.
Advantages of Short Term Loans
- Less interest: As these are to be paid off in a very short period within about a year, the total amount of interest cost under it will be least as compared to long term loans which take many years to be paid off. The long term loan total interest cost might be more than the principal amount.
- Disbursed Quickly: As the risk involved in defaulting of the loan payment is lesser than that of the long term loan as they are having a long maturity date. Because of this, it takes lesser time to get sanctioned the short term loan as their maturity date will be shorter. Thus one can get the loan sanctioned and fund disbursed very quickly.
- Less Documentation: As it is less risky, the documents required for the same will also be not too much making it option for all to approach for short term loan.
Disadvantages of Short Term Loans
The main disadvantage of the short term finance is that one can get a smaller amount of loan only and that too with shorter maturity date so that the borrower won’t get burdened with bigger installments. It is fixed that period of loan will be less than 1 year and if a high amount of loan is sanctioned, the monthly installment will come very high resulting in an increase in the chance of default in repayment of loan which will affect the credit score adversely.
It can leave the borrower with no other option than to come into the trap of the cycle of borrowing in which one continues borrowing to repay the previous unpaid loan. In this cycle, the interest rate keeps on increasing and can terribly affect the business and its liquidity.
Important Points to Note
- The main agenda of opting for short term finance for a business is to get fund for working capital so that the cycle runs efficiently and the fund does not become the hurdle in the day to day business.
- If the person is unable to repay the loan then it will affect its credit score as well
Short term loans are very helpful not only for businesses but also for individuals. For business, this resolves the problem of sudden cash flow and in the same line, it resolves the problem of an emergency fund for the individual. The consequences of nonpayment of installment of short term loan can be very dangerous as not only it will affect the credit score but will increase the financial burden and hurdle in day to day business operation. It is advisable to properly go through the projected business and cash flow before opting for finance.
This has been a guide to what is Short Term Financing & its definition. Here we discuss the top 5 types of short term financing along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –