When small business owners find themselves short on cash, many take on short-term debt in hopes that quick funding will help them overcome the cash crunches they’re facing.
But are short-term loans the best solution? In this article, we explain what a short-term loan is and offer advice to help you determine the best solution for your business’s needs.
What is a short-term business loan?
Short-term loans are essentially funds that are paid back within 12 months, although some require repayment in as little as 3 to 6 months. Importantly, they also have annual percentage rates (APRs) that are higher than longer-term loans, include more fees and penalties, and have repayment schedules that can be difficult for small businesses to payback, such as weekly or even daily payments.
Types of short-term business loans:
Merchant cash advances: With a Merchant Cash Advance (MCA), lenders provide cash to a business owner in exchange for a percentage of their daily credit card transactions. Fees and interest rates also apply with this type of lending. The borrower makes payments on the MCA continuously until the total debt is paid off. While this is a common source of short-term funding for small businesses, it often leads to accumulating cash flow problems.
Accounts payable: Accounts payable (AP) is a company’s liability due within 12 months to its creditors, vendors and suppliers. In other words, AP is an obligation that a business has to a creditor, vender or supplier for goods or services that were provided in advance of a payment. This debt is usually reported on the balance sheet as a current liability.
Sometimes business owners can negotiate extended payment terms, giving them additional time to pay the debt. In this case, a business owner requests special terms, such as an option to make a larger payment at a later date, usually with a penalty fee or accrued interest.
Invoice discounting: Sometimes referred to as invoice financing, this is an option when your business has accounts receivable (AR) that are due soon, generally not older than 60 or 90 days. In this case, a lender may loan your business an amount that’s equal to a percentage of the outstanding AR (typically, about 75 to 80%). While it’s assumed that your customers will eventually pay, these loans can be costly if they don’t, or if they take excessively long to remit payment.
When are short-term options the right solution?
Short-term funding options are only recommended in a few circumstances when you’re absolutely certain that the funds can be paid back quickly. Otherwise, there are several better options. Here are a few examples of when short-term business loans can be useful:
You need help financing your inventory. Every business has an operating cycle, which refers to the amount of time it takes to purchase inventory, sell it and collect payment from the sale. At times, businesses might experience a delay in collecting payments from their clients, causing cash flow issues. If your business doesn’t receive payment from its sales, it won’t have the money to purchase the necessary inventory to continue its operating cycle.
In this scenario, short-term financing could help prevent cash flow and inventory issues. It’s important to note that these short term loans, should be paid back as soon as the business collects payment from the client.
You have a business emergency, such as loss of equipment due to a natural disaster, and you know that you’ll be repaid through insurance but need to replace equipment to get up and running prior to when the reimbursement is made.
You have a one-time, short-term need. This could be from a working-capital gap due to AR delays or a delay in operations, such as an extension to a business-opening date. In these cases, you know that revenue will be received or generated soon, although you may not have it in-hand yet.
When are other funding options better?
In nearly all cases, there are better funding solutions that can help cover a variety of needs, than short-term loans. They range from business lines of credit and mid-term loans (typically, about 24 to 60 months) to longer-term loans. Even business credit cards that offer 0% financing for a set term (usually, about 6 to 12 months) can be better options.
Talk to EGF about real solutions that benefit your business today and for the long term
There are many reasons why small businesses need short-term funding but often, these issues are better managed by proactively seeking longer-term solutions to situations that could cause cash flow shortfalls. Contact EGF’s Business Advisors today to find out how we can help your business through loans with lower interest rates and fees, no prepayment penalties and easy-to-manage repayment schedules. We’re a nonprofit lender whose primary goal is to help small businesses achieve success.