What is short-term financing?
Short-term financing occurs when a company finds an external funding source to run the business for a short period of time that takes less than a year to pay off. Working capital financing is another term for short-term financing. When a company's cash flow from operations is uneven, short-term financing is used to generate cash flow and cover operating expenses. Short-term finance is typically used by businesses to fund inventory, accounts receivable, and loans.
Types of short-term financing
Suppliers of purchased goods offer trade credit on agreed-upon terms for a period of 15 to 90 days. The supplier delivers the goods to the organization in anticipation of future payment based on the sale invoice. With the organization, the supplier has established a trade credit limit. A trade credit helps an organization manage and reduce its capital requirements. It is an important source of short-term financing for a business because it incurs no additional costs until the period ends. To obtain a trade credit, the organization must be creditworthy and gain the trust of its suppliers. If the organization fails to pay the trade credit on time as agreed, it will be charged additional fees and will lose the opportunity to receive a discount on the received goods.
Accounts receivable credit
Financial institutions such as commercial banks provide account receivable credit. Factoring is another term for account receivable credit. A bank provides financing solely by discounting the invoice or bills. The company sells its receivables to a factor at a lower rate than the net value. An organization can get immediate cash for credit sales by selling invoices to a factor. A factor is a financial institution that provides services related to debt management and financing resulting from credit sales. When an organization's cash inflow is reduced due to short-term debts that exceed sales revenue, factoring is the best short-term financing option to recover the revenue. Factoring services include taking over the administration of credit sales, maintaining the sales ledger, collecting accounts receivable, protecting against bad debts, and providing advisory services to their clients.
Commercial bank loans
Commercial loans are short-term loans made available by commercial banks. This type of short-term loan is obtained to finance the organization's working capital, purchase new machinery, purchase production supplies, and cover operating expenses. A commercial short-term loan is typically given against collateral security so that the bank can take over the security in the event of the organization's default payment. Interest rates will be charged on borrowed loans beginning on the date the lender bank approves them.
Indigenous bankers are individuals or private companies that provide loans in the capacity of a bank. Their primary business is lending money. To finance his business operations, a small business owner will look for a private lender. Because the lender does not obtain sufficient documentation to provide financing, the interest rates charged by a private lender are typically higher than those charged by other financial institutions. This is an immediate short-term loan for small business entrepreneurs to meet their working capital needs.
A commercial paper is a type of unsecured short-term financing issued by businesses. Its expiration date ranges from 30 to 270 days, but not more than one year. A commercial paper is issued at a discount to its face value and then distributed to banks and other investors. The borrower would repay an amount equal to the face value.
Importance of short-term financing
- When cash flow is low, short-term financing can help to fund the business's short-term needs.
- Short-term financing aids in the development of a business by allowing it to purchase new machinery and equipment.
- Short-term financing protects the company from unforeseen expenses.
- Short-term financing aids in the funding of working capital and other expenses.
Advantages of short-term financing
Less interest payment
Short-term loans will be paid off within a year, and the interest rate will be lower than that of long-term loans.
Due to the low risk of short-term financing, the loan payment is available in a short period of time. Because this is a short-term loan, the maturity date is also shorter than that of other loans. As a result, short-term loans can be disbursed quickly. This is an excellent source of financing for a small business that can be obtained quickly.
Short-term loans typically provide the borrower with a small sum of money. In comparison to long-term loans, the lender can make loans with less difficulty. As a result, the organization can easily obtain short-term loans.
Short-term financing requires very little documentation process because of the small amount and short maturity period.
Disadvantages of short-term financing
Because the application process is less stringent, most short-term loans have higher interest rates. It is preferable to repay the loan as soon as possible to the lender in order to reduce the interest cost.
It carries a high level of risk in the event of nonpayment. Default payment has an impact on the creditworthiness of the business and creates a terrifying image in the mind of the lender.
Context and Applications
This topic is important in professional exams for undergraduate and postgraduate courses for master of science in supply chain management, master of science in management, master of business administration in global banking, certified fund specialist, and certified investment management analyst.
Question 1: A short-term loan will have a maturity period of no more than ___________.
1) 180 months
2) 989 days
3) 12 months
Answer: Option 3 is correct.
Explanation: Short-term financing typically takes 365 days to pay off the amount borrowed, with a maximum term of one year. When compared to other long-term business loans, it has a very short repayment period.
Question 2: Obtaining a loan from a private lender at a higher interest rate to meet a small business entrepreneur's need for working capital is ______________.
1) Indigenous banker
2) Trade credit
3) Commercial paper
Answer: Option 1 is correct.
Explanation: Indigenous bankers offer higher interest rates on business loans. Small business owners seek this type of short-term loan to meet their company's financial working requirements.
Question 3: ___________ is a primary service factor..
1) Discounting bills
2) Maintain cash flow
3) Give short-term loans only
Answer: Option 1 is correct.
Explanation: Factoring is the practice of selling accounts receivable to a factor. The factor could be a bank or any other financial institution that offers the basic service of discounting bills by paying the selling organization in cash right away.
Question 4: Commercial paper is a type of __________________.
1) Lon-term financing
2) Short-term financing
3) Midterm financing
Answer: Option 2 is correct.
Explanation: Commercial paper is a type of short-term financing in which an organization raises funds to meet business needs for a period of up to one year.
Question 5: Choose the appropriate short-term loan from the list below:
1) Car loans
2) Long-term payday loans
3) Commercial loan
Answer: Option 3 is correct.
Explanation: Commercial loans are typically granted for a period of no more than one year. A business loan that is granted for a period of up to one year is a source of short-term financing.
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