The Disadvantage & Advantage of Short-Term Financing

by Maria Kielmas, Demand Media Google
    Too much short-term financing is dangerous for small businesses.

    Too much short-term financing is dangerous for small businesses.

    Short-term financing is a method of raising funds involving financial obligations that need to be repaid within a year or less. It is a fast and flexible way for companies to obtain working capital for their daily operations when their cash flow is insufficient. The main disadvantage is that a company may become too reliant on short-term funds and vulnerable to high interest rates and banking fees. This may adversely affect profit margins. Short-term financing can cover payroll, utility charges and the purchase of raw materials by the business. Overdrafts, short-term bank loans, and trade credit are types of short-term financing.

    Speed

    Short-term loans can be obtained much faster than long-term financing. Lenders do not make as thorough an examination of a company’s accounts for short-term lending as they do in the case of long-term loans. Small- and medium-size companies often do not have large cash reserves and are vulnerable to sudden financial shocks such as bankruptcy or of non-payment by a key debtor.

    Flexibility

    Small companies often have seasonal variations in cash flow and need access to capital over that period. Overdraft protection is a form of short-term finance where a bank agrees to pay a company’s checks, electronic debits, and cash withdrawals to a certain limit. The lender charges a fee for this facility and interest on any balance outstanding. The costs of long- term debt may be greater than those for such a short-term facility. Lenders can charge a premium if a debtor repays a long-term loan before its maturity. But the drawback to this kind of short-term finance flexibility is that the bank may withdraw the overdraft protection on short notice.

    Management

    Lenders who extend short-term financing do not involve themselves in company management or in the business’ decisions about capital investment. Long-term finance is accompanied by a number of provisions, such as limits on other financial arrangements or caps on the salaries of company principals, that restrict the business’ actions.

    Risk

    Market circumstances, such as a recession, may push small businesses into borrowing too heavily on a short-term basis. Short-term finance can be a serious risk for the borrower. A short-term loan may be renewed by the lender on much less favorable terms than the original contract. Not only is the business faced with the high cost of the capital, it may not be able to service the accumulated debt. This leaves the company in a weak position where it could face bankruptcy.

    Trade Credit

    Trade credit allows a company to buy materials and services and pay for them at an agreed later date. Although this eases the buyer’s cash position, he may be locked out of any discounts the seller may offer in return for immediate payment. The buyer may also have to cover his own non-payment risk by contracting a standby letter of credit from his own banker. This guarantees payment to the seller. But this will cost the buyer a further 1 percent to 8 percent of the face value of his contract with the seller.

    About the Author

    Based in London, Maria Kielmas worked in earthquake engineering and international petroleum exploration before entering journalism in 1986. She has written for the "Financial Times," "Barron's," "Christian Science Monitor," and "Rheinischer Merkur" as well as specialist publications on the energy and financial industries and the European, Middle Eastern, African, Asian and Latin American regions. She has a Bachelor of Science in physics and geology from Manchester University and a Master of Science in marine geotechnics from the University of Wales School of Ocean Sciences.

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