What are the main types of secured and unsecured short-term business financing?

How do businesses raise money? One, they borrow it (debt). Two, they use the owners’ own funds (equity). Three, they keep the profits they already earned (retained earnings). The financial manager weighs all three and selects the mix that adds the most value to the business. There are advantages and disadvantages to each type of financing and each type of financing source.

Anything under a year is generally defined as short-term debt. Anything longer than one year is usually considered long-term debt. Short-term debt is usually held within current liabilities and comes due during the current operating period. Current debt pays for current assets and daily operations. Debt can be secured and unsecured. Secured is when there is something the borrower promises to the lender in case there is a payment default. Unsecured has no collateral.

Three Main Types of Unsecured Loan

Many loan agreements are unsecured. The lender is relying on the creditworthiness of the borrower and past experience with it. No specific assets are pledged. There are three main types of unsecured loan: trade credit, bank loans and commercial paper.

Trade credit is when a supplier sells a product to a business and bills the customer for it. The buyer would not pay at the time of the sale, but at some later date as agreed to by the parties. When a tire company ships tires to a car manufacturer, the tire company doesn’t get paid immediately. It “bills” the car company for the tires, and it won’t get paid until the car company pays the bill. The tire company books the “accounts receivable” and the car company books the “accounts payable.” It’s really just a short-term loan. Trade credit is one of the largest sources of short-term debt.

Many short-term loans from banks are unsecured. There are two kinds of unsecured bank loans, and they are often for seasonal or cyclical businesses. One kind is called a line of credit and the other is called a revolving credit agreement. A line of credit is the maximum amount the bank will let a borrower borrow for a period, generally a year. Revolving credit is similar to a line of credit except that a borrower pays an extra fee on top of the interest rate for a guaranteed line of credit.

Commercial paper is unsecured IOU (I owe you) paper sold by financially secure companies. Commonly sold in multiples of $100,000, for periods ranging from three days to 270 days. Commercial paper can have rates of interest lower by 1-3% than that offered by the bank. Because of this many large companies prefer this method of short-term financing. Commercial paper is also considered a short-term investment.

Secured Loans

A secured loan is where the borrower pledges particular assets as collateral. The lender may legally seize the assets if payments are not made. Secured loans are generally used when the borrowers credit standing is too weak to qualify for an unsecured loan. Collateral is generally the receivables or the inventories of the business. Receivables are fairly easy to turn into cash and therefore are good collateral. Inventories are worth only what they can be fairly resold for. They aren’t always good collateral.

Factoring is where the firm sells its receivables outright to a factor, a firm that buys receivables, often a commercial bank or commercial finance company, at a discount. This is common in the apparel, furniture and appliances industries. Factoring costs more than a bank loan, obviously, because of the discount.

Many firms with steady orders don’t have the cash on hand to make payroll and pay bills. One option is to factor their invoices. The factor then collects the invoices over time. Factoring is not a loan. It is the actual sale of the invoices. For example, a trucking company has a lot of freight bills. The freight carrier doesn’t get paid up front. However they do get a signed invoice from a customer who will pay them later.