What are the pros and cons of short-term financing for a small business?

Small business owners typically turn to banks for financing and bank loans when cash gets tight. Those bank loans don’t always come easy, though, and when they don’t, entrepreneurs suffer.

In the past, business owners would sweat these events and hope for the best. These days, there are better options for making it through those surprise expenses and making sure a weak cash flow period doesn’t mean a weaker business. Most fall under short-term financing.

While short-term financing can be a great option for covering those unexpected expenses, no financial decision is without its drawbacks.

We’ll look at some of the best and worst things about the choices available to get you ready to decide whether they’re right for you.

Short-term financing includes any business credit you’ll be expected to pay back within a few months, usually three to six. Conventional short-term loans count, of course, but here we will largely exclude them from the discussion. Bank overdrafts are out too. We’ll be looking at some of the most common sources small businesses use for cash.

Startup loans are paid back over years, but short term financing is due months from now at the latest. It can take years to see profits from an investor’s money. It’s not uncommon for more than one funding round to take place before investors see returns. Others await a sale or IPO.

There are many business needs which require cash for a few months but not much longer. Short-term financing suits fairly urgent needs like buying in stock, paying staff for a seasonal project or a time-limited marketing push. It can be great for that.

Short-term financing comes in various forms.

Invoice factoring lets you sell your outstanding invoices to a third party, known as the factor. They give you cash for the credit due now and take over collecting the actual payments from your customers.

Invoice financing, also called invoice discounting, gives you an advance on your outstanding invoices. It’s like factoring except that in discounting the business keeps the invoices and collects the credit owed. In order to get a loan, your outstanding invoices prove you’ll pay back the lender.

Accounts payable financing, also called inventory financing, lets you borrow against unpaid supplier invoices. A third party pays the supplier invoice up front for a fee, and you pay your invoice to them later.

Revenue-based financing means taking out credit you pay back as a percentage of your business’ future sales. Repayment is required within a set period.

Short-term Financing Can Boost Your Business

There are many reasons a short-term loan can be a helpful option. Here are some of the best.

Short-term financing can usually be had far more quickly than traditional financing options like bank loans or venture capital investment. Loans from banks typically require a lot of paperwork and due diligence. Venture capital is a long-term funding process that requires as much commitment on the investor’s part as the recipient’s.

Due diligence is not just for banks, and some factoring deals have even been known to drag out for months. But as far as any credit product goes, short-term financing options tend to be some of the quickest.

In an ideal world, you apply and find out almost instantly whether you are eligible.

When you need cash, you need it quickly. Even a bank loan, once approved, can involve several extra sign-off steps and stand-down periods before the money is handed over. Short-term financing generally has fewer bumps along the road.

Renewing and refinancing a short-term financing loan is usually as quick as the initial application and approval. A good history of meeting your obligations is often the best qualification for even more funding. Taking out short-term financing for your small business doesn’t have to be a one-off fix. When used to its full potential, short-term financing can boost your business for the long haul.

Managing your cash flow is often the reason to turn to short-term financing. Short-term financing makes it possible to pay staff and suppliers for a few months before getting paid yourself.

Any credit that lets you use cash for extra time helps improve your cash conversion cycle. Invoice financing can work like a cash injection by giving you money now for invoices that aren’t due for some time. That lowers your Days Sales Outstanding, a key factor in maintaining a healthy cash flow.

It feels good to know you’ll have paid off a lender in a matter of months, and not worry about keeping them on the balance sheet for years.

Some traditional lenders insist that you hold your credit for a certain amount of time. They’ll charge you for paying it off early, and sometimes put up extra red tape to slow the process.

You want freedom to take on and pay off credit when it makes sense for your business.

Bank loans tend to come in standard packages designed with the lender’s needs in mind. You can look around, but you might not get a loan that gives you the exact amount you need.

Not all short-term financing options are adaptable to your needs. Luckily there is more than one kind of short-term financing. Factoring might not work for your business, for instance, but inventory financing could.

Modern providers have made it so you can access a loan when you need it, on your schedule. You don’t need to be locked into a long-term lending relationship, either. Short repayment terms mean you avoid being stuck with a single lender if their deal doesn’t suit you in the long run.

If you need extra cash after a slow summer, it won’t make sense to draw out credit over many years when you’ll only need the cash for a season. The same goes for sudden opportunities. Longer-term funding isn’t right for those moments.

Money you’re after for major purchases or new hires may come from equity or a long-term bank loan. As vital as long-term bank loans or venture capital deals are for pushing your business into new phases, they’re not always right for smaller, immediate needs.

For that, there’s short-term funding.

Short-term Financing May Not Be the Best Choice

It’s not all sunshine.

Here are some of the reasons short-term financing may not be the best choice.

Some short-term financing options can be more costly.

Factoring and invoice discounting tend to cost the most. They can take 0.5% to 5% of invoice value in fees, plus commission (interest) and admin and collection fees. Factor’s fees may seem small, but they can pile up quickly with many invoices.

Sometimes the cost is well worth the value. Weigh the cost before you sign.

Most short-term loans come in smaller amounts than long-term bank loans or an equity deal with an investor. That may not be a bad thing, however. The amount you take out affects your total repayment, so it’s natural for smaller loans to be repaid in a few months. A loan for a few thousand or low tens of thousands of dollars is great for things like paying staff, suppliers, or a marketing push.

Luckily, lenders often offer more cash and better terms to businesses who can show they are trustworthy borrowers.

When used responsibly, short-term financing can help grow your business without draining your savings.

Repeat debts can be a good thing. For some industries it may be normal to have a heavy season, and it makes sense to expect cash lows when the cycle repeats. In those cases, seasonal borrowing, or recurring borrowing, with a clear repayment plan can be a great answer to cash gaps. An ad agency, for instance, puts in long hours in the months before the winter holidays only to have the major payouts after the new year starts. Payment can come slowly after a grower’s harvest.

Beware though; don’t borrow just for the sake of repaying the last lender. Soon, the costs will pile up and the hole just gets deeper.

No matter what kind of credit you choose, use it with a clear strategy, and a backup plan, to be sure you can pay when debts come due.

Lending always involves risk to your finances, and short-term loans are no exception. Slow pays get expensive as you pay late fees and rising interest. If debts run up to late payments, then to fees, and finally into another loan to cover them, you could be on a path to danger.

Before you take out credit, be sure you understand exactly the costs, risks and benefits. It’s not always a good idea to pledge collateral, and think twice before you sign your name to personal guarantees. They both mean extra risks to your business and yourself.

Right for You

Is a short-term loan right for you? It all depends on the state of your company and your own preferences. The right short-term financing for you could look very different than the best choice for your neighbour’s business.

It works better for certain kinds of companies.

• Companies that need funds urgently.
• Companies that want flexibility without long commitments.
• Companies with a clear plan for the cash.
• Companies that hold unpaid invoices, owed or owing.

This goes for many small businesses from service firms to agencies and hospitality.