Short Term Financing

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Short Term Financing Definition

Short-term financing means business financing from short-term sources, which are for less than one year. The same helps the company generate cash for working of the business and for operating expenses, which is usually for a smaller amount. It involves developing money by online loans, lines of credit, and invoice financing.

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 cycleBusiness CycleThe business cycle refers to the alternating phases of economic growth and decline.read more.

Key Takeaways

  1. Business finance from short-term, typically less than a year, sources is referred to as short-term financing.
  2. Examples of short-term finance include invoice discounting, working capital loans, factoring, trade credit, and business lines of credit. 
  3. Short-term financing requires less interest and documentation and is disbursed quickly.
  4. The primary goal of short-term financing for a firm is to obtain working capital funds to ensure that the cycle continues smoothly and the funds do not constitute a barrier to regular business operations.

Types of Short Term Financing

Below are the types of Short Term Financing

#1 – Trade Credit

This is the floating time that allows the business to pay for the goods or services they have purchased or received. The general floating time allowed to pay is 28 days. This helps the businesses manage their cash flows more efficiently and help deal with their finances. Trade creditTrade CreditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front.read more is a good way of financing the inventories, which means how many days the vendor will be allowed before its payment is due. The vendor offers the trade credit as an inducement in a continuing business, which is why it costs nothing.

#2 – Working Capital Loans

Banks or other financial institutions extend loans for a shorter period after studying the business’s nature, working capital cycle, records, etc. Once the loan is sanctioned and disbursed by the bank or other financial institutions, it can be repaid in small installments or paid in full at the end of loan tenure, depending on the agreed terms of loans between both parties. It is often advised to finance the permanent working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more needs through these loans

#3 – Invoice Discounting

It refers to arranging the funds against submitting invoices whose payments will be received shortly. The receivables invoices are discounted with the banks, financial institutions, or any third party. On submission of bills, they will pay the discounted value of bills, and on the due date, they will collect the payment on the business’s behalf.

#4 – Factoring

It is a similar arrangement of finance like invoice discountingInvoice DiscountingInvoice discounting refers to invoice financing where businesses borrow money as loans from finance companies by keeping the amounts due from customers as the collateral, accounts receivable is used as collateral, and finance companies, in return, issue the loan less than the amount receivable as per the invoice.read more. It is debtor finance in which businesses sell their accounts receivable to a third party whom we call factor at a lower rate than the net realizable valueNet Realizable ValueNet Realizable Value is a value at which the asset may be sold in the market by the company after deducting the expected cost of selling the asset in the market. It is a crucial metric for determining the value of a company's ending inventory or receivables.read more. 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 a certain amount based on their credit lineCredit LineA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more structure judged through a credit score, a business model, and projected inflows. Then, the business can withdraw the amount as and when needed, subject to the maximum approved amount. Then, 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 the daily reducing balance method. In this manner, it becomes a very cost-efficient mode of financing.

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Example of Short Term Finance

Marry took a loan of $10,000 for six months at the 5% APR. Since the loan is for a shorter period, i.e., less than one year, it will be treated as short-term finance. After six months, the marriage has to repay the loan amount and the interest due.

Short Term Financing

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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 that take many years to be paid off. The long term loan total interest cost might be more than the principal amount.
  • Disbursed Quickly: The risk involved in defaulting the loan payment is lesser than that of the long-term loan as they have a long maturity date. Because of this, it takes less time to get sanctioned the short-term loan as their maturity date will be shorter. Thus one can get the loan sanctioned and the 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 an option for all to approach short-term loans.

Disadvantages of Short Term Loans

The main disadvantage of short-term finance is that one can get a smaller loan and a shorter maturity date so that the borrower won’t get burdened with bigger installments. However, it is fixed that the loan period will be less than one year. Therefore, if a high amount of loan is sanctioned, the monthly installment will come very high, increasing the chance of default in repayment of the 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 increases, affecting the business and its liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more.

Important Points to Note

  • The main agenda of short-term finance for a business is to get funds for working capital so that the cycle runs efficiently and the fund does not become a hurdle in the day-to-day business.
  • If the person is unable to repay the loan, it will affect their credit score.

Conclusion

Short term loansShort Term LoansShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more 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 fundEmergency FundAn emergency fund is a source of money that you refrain from spending and store away safely to use in the time of need. Since it is readily available for withdrawal, savings invested in the emergency fund act as a savior during unforeseen circumstances. The emergencies can be a sudden job loss, emergency medical issues, or big losses in the financial market.read more for the individual. However, the consequences of nonpayment of the installment of short-term loans can be very dangerous. It will affect the credit score and increase the financial burden and hurdle in day-to-day business operations. Therefore, it is advisable to properly go through the projected business and cash flow before opting for finance.

Frequently Asked Questions (FAQs)

What is the difference between short-term and long-term loans?

The repayment period for short-term loans ranges from one to five years. However, the loan duration for long-term loans might range from 10 to 20 years.

What are some examples of short-term financing?

The main forms of short-term funding are trade-secured loans, credit, commercial paper, commercial bank loans, a specific type of promissory note, and commercial paper.

Why is riskier short-term financing?

The biggest issue with short-term financing is reputational risk. However, the use of collateral and the short-term nature of the transaction mitigate the credit risk to a financial institution.

Why is short term financing important?

Most short-term loans are returned in a year or less. Less time in payments indicates a lower total amount of interest over the loan’s life. You can easily raise your business credit score by making these payments on schedule and repaying the loan.

Recommended Articles

This has been a guide to 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 –

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Comments

  1. David says

    good notes well explained indeed

    • Dheeraj Vaidya says

      Thanks for your kind words!

  2. David says

    good notes well explained indeed

    • Dheeraj Vaidya says

      Thanks for your kind words!

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