Let’s look at the comprehensive overview of short-term financing, defined as loans or debts intended for repayment within a year. It explores the two main sources: spontaneous sources, which arise naturally from business operations, and negotiated term financing, which requires strategic planning. The piece also discusses the characteristics of secured short-term loans, emphasizing that lenders prioritize timely repayment over collateral.
Finally, it outlines thirteen key features of short-term financing, including its purpose, cost, risk, and renewal process. This guide offers valuable insights into the crucial role of short-term financing in business.
Table of Contents
What is Short-term Financing?
Short-term financing is a loan or debt that is set up to have payment made in a short period; it can also mean repayment must be made in less than a year.
Sources of Short-term Financing
The source of short-term financing can be classified into two broad heads: one is spontaneous sources, and another one is negotiated term financing.
Spontaneous Sources
Spontaneous liabilities arise from the normal course of business. The two major spontaneous sources of short-term financing are accounts payable and accruals.
As the firm’s sales increase, accounts payable increase in response to the increased purchases necessary to produce at higher levels.
Also, in response to increasing sales, the firm’s actuals increase as wages and taxes rise because of greater labor requirements and increased taxes on the firm’s increased earnings.
There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs.
Also, both are forms of unsecured short-term financing-short-term financing obtained without pledging specific assets as collateral.
The firm should take advantage of these “interest-free” sources of unsecured short-term financing whenever possible.
Negotiated Term Financing
It refers to the sources where the finance manager needs to put some effort into financing the business. Different mechanisms are available to execute the negotiated term financing. However, each of the sources under the negotiated term financing has its characteristics.
Characteristics of Secured Short-Term Loans
Although many people believe that holding collateral as security reduces the risk of a loan, lenders do not usually view loans in this way.
Lenders recognize that holding collateral can reduce losses if the borrower defaults, but the presence of collateral has no impact on the risk of default.
A lender requires collateral to ensure recovery of some portion of the loan in the event of default. What the lender wants above all, however, is to be repaid as scheduled.
In general, lenders prefer to make less risky loans at lower rates of interest than to be in a position in which they must liquidate collateral.
Collateral and Terms
Lenders of secured, short-term funds prefer collateral that has a duration closely matched to the term of the loan.
Current assets—accounts receivable and invenÂtory—are the most desirable short-term loan collateral because they can normally be converted into cash much sooner than fixed assets.
Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral.
Typically, the lender determines the desirable percentage advance to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 140 and 100 percent of the book value of the collateral.
It varies according to the type and liquidity of collateral.
Lenders do not normally consider secured loans less risky than unsecured loans; also, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans.
The lender, therefore, normally requires added compensation in the form of a service charge, a higher interest rate, or both.
13 Characteristics of Short-Term Financing
- Time or Period.
- Purpose.
- Cost of Funds.
- Risk.
- Sources.
- Renewal.
- Recycling.
- Security.
- Size & Nature of the Firm.
- Clean-Up.
- Speed.
- Less Restrictive.
- No prepayment penalty.
Time or Period
Short-term financing involves collections of funds that require repayment within one year or less.
Purpose
Short-term financing is generally used for meeting working capital needs, e.g., the purchase of raw materials, wages, and other daily expenditures.
Cost of Funds
Some short-term funds are more costly than intermediate or long-term funds, while others provide funds at no cost at all.
Risk
Short-term credit is riskier for two reasons:
- If a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense will fluctuate widely, at times going quite high,
- If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt, which could force the firm into bankruptcy.
Sources
Short-term finance mainly deals with trade credit, money market credit, and secured and unsecured bank loans.
Renewal
Institutions, such as commercial banks and other financial institutions, provide short-term loans, which can be renewed under certain conditions if repaid within due time.
Recycling
Short-term finance provides funds that are continuously rolled over. For example, if a business organization purchases raw materials on credit and payments are made within the due date, the supplier will be satisfied and allow future credit purchases.
Security
As the payment is made shortly, no security is generally required.
But there are some sources, such as bank loan, which is provided judging the capacity and acceptability of the debtor. As a result, bank loans can be both secured and unsecured.
Size & Nature of the Firm
Small, medium, and large, all types of manufacturing and merchandising organizations use short-term financing. However, merchandising businesses require relatively more short-term financing than manufacturing concerns.
Again, there is a common tendency for greater use of short-term financing among small and medium concerns and lesser use among large concerns.
Clean-Up
Commercial banks or other lenders sometimes require the firm to pay off its short-term obligation, just as some sources are rolled over; some must be reduced to 0 or cleaned up at one point in the year.
Speed
A short-term Ipan can often be obtained much faster than long-term credit or any other loan.
Less Restrictive
Short-term credit agreements are generally less restrictive in terms of provisions or covenants, which impose very little constraint on the firms’ future actions.
No prepayment penalty
Short-term credit can be repaid before maturity without incurring any prepayment penalty.
Conclusion
In conclusion, understanding short-term financing is crucial for effective financial management. Its sources, characteristics, and strategic use are key to maintaining liquidity and supporting operational needs. This knowledge empowers businesses to make informed decisions, ensuring financial stability and fostering sustainable growth.