Definition:
Short-term finance refers to a business’s need to raise funds for a period, not more than twelve months. Usually, short-term finance is used to manage the working capital of the business and even short-term investments. It can also be an excellent source of funds in case of an emergency. Bank overdraft is a Prime example of short-term finance.
Detailed concept
It’s not always easy for small business setups and startups to arrange long-term financing due to less credibility and a higher risk of default. So, they look for options related to short-term financing.
Following are some of the circumstances that enhance the need of the business to raise the finance,
- Seasonal pattern of the business sales leading to the fluctuation in the production and working capital requirements.
- Uneven pattern of the business cash flow leading to raise the short term financing.
In addition, this type of short-term financing is used for inventory financing, accounts receivable financing, or even for accounts payable financing. Sometimes specific sales orders are met with this type of financing as the business might need to enhance operational capacity related to fulfillment of orders.
There are multiple ways to raise the finance via short term financing that include the following,
1-Creditors
Businesses have a floating period during which they can pay for the merchandise or the services they have availed, purchased, or received. Payouts are generally allowed to float for 28 days. Managing cash flows in this way allows businesses to deal with finances more efficiently.
Furthermore, trade credit is the financing of inventories. And it is a vital aspect of the business, as it allows the vendor to have a certain amount of days before they have to pay. The vendor offers the trade credit as an incentive to continue the business, not cost anything.
However, there is a limit of certain days, and the business has to pay back. Otherwise, there can be impairment in working relations with the suppliers.
2-Invoice Discounting
Invoice discounting is another beneficial short-term financing related to the organization’s specific accounts receivable/invoice. In invoice discounting, the organization pledges the company’s accounts receivables/invoice to banks, financial institutions, or third parties.
In this process, the bank or third party will pay out the sum to the owner of accounts receivables after discounting and collect the accounts receivables on behalf of the business whenever they are due. However, invoice discounting does cost the business as bank or third part deducts a certain percentage on making a payout.
3-Business Line Of Credit
The business line of credit is the limit that is granted to the businesses for raising the finance. For instance, the creditor may approve a credit limit of $50,000, and the business may obtain $40,000 with further capacity to borrow $10,000. So, it’s the discretion of the business regarding the amount they want to raise in line with the business needs. Further, interest is only charged on the funds that have been raised.
In other words, the banks or financial institutions are authorized to finance a specified amount through this method. A business may make payment and continue to deposit once the customer has made a payment within the specified amount.
It’s more like a revolving credit, which serves the organization with the advantage of charging interest only on the amount due, or that was utilized and not on the approved limit. To save on interest costs, the business can deposit unused amounts. Hence, this is a highly cost-effective option of financing.
However, the business needs to remain active in managing finance and other aspects of business management for effective utilization of the business line of credit.
4-Factoring
Factoring is another source of short-term financing, and it is similar to invoice discounting. In this type of financing, the accounts receivable of the company are pledged or sold to a third party. The price under consideration for this type of arrangement is less than that of the net realizable value of the accounts receivables.
The difference between invoice discounting and factoring is that invoice discounting is about specific invoices, and factoring can be on the pool of debtor balance.
5-Working capital loans
Financial institutions and banks can provide short-term loans. This type of loan is extended after banks carefully examine an organization’s working capital cycle, track record, and dealings with other organizations. After the loan is taken, the loan is repayable in small partial payments, installments, or in full.
6-Merchant cash advance
Financing via merchant cash advance enables the business to obtain lump sum funds pledged against future sales. That’s an ideal source of financing for the businesses that generate revenue with the credit card as these financing companies mostly rely on the sales generated through cards.
Difference between short term and long term finance
Following are some of the differences between internal and external sources of finance.
| Short term source of finance | Long term source of finance |
| The debt does not remain outstanding for more than twelve months. | The debt remains outstanding for more than twelve months. |
| Presented as a short-term liability in the balance sheet. | Presented as a long-term liability in the balance sheet. |
| Mostly, obtained to finance the working capital. | Mostly, obtained to finance investments. |
| Assessment of the business liquidity is included in the analysis for the company’s ability to pay off bills and the related invoices that are due/about to. | Included in assessment of the business gearing and, in other words, included in the analysis for assessing the debt and financing structure. |
| The contracts to raise short-term financing are usually less restrictive in terms of covenants and other compliance-related aspects. | The contracts to raise short-term financing are usually more restrictive in terms of covenants and other compliance-related aspects. |
| Limited funds can be raised with short-term financing and are usually used to finance small projects. | Large funds can be raised with long-term financing and are usually used to finance large projects. |
| It’s logical to use these funds for working capital management, rather than capital intensive items like the purchase of Property, Plant, and Equipment, etc. | It’s logical to use these funds for capital-intensive works like the purchase of Property, Plant, and Equipment, etc. |
| It’s considered a more flexible approach to financing as the business has more discretion to make decisions regarding sources of finance and other aspects. | It’s considered a less flexible approach as businesses enter into a contract for a lengthy period. However, restructuring and other modifications are still possible. |
| Higher influence has been observed on the cost of interest for changes in the country’s economic conditions. | Economic effects on the cost of interest are limited, and the interest rate is relatively stable. |
| Bank overdraft is a prime example of short-term finance. | Thirty years mortgage is the prime example of long-term finance. |
Advantages of short term finance
Following are some of the advantages related to short-term financing.
- Higher flexibility – Short-term finance is raised for a limited time. So, the business management can decide if they want to obtain the next financing with some changes/modifications in the terms and conditions. Hence, there is higher flexibility.
- Quick availability – The speed of raising finance with short-term finance is higher, and even funds can be obtained within a week. So, there is no match of the short-term financing when we speak in terms of availability.
- Fewer formalities and covenants – Short-term finance is granted for a limited time. So, few formalities and covenants need to be complied with as the lender’s perceived risk is limited.
- Higher credit rating is not required – Usually, short-term lenders are not much concerned about the credit rating. On the other hand, banks and other institutions may be very sensitive and even reject loan applications in the first screening if the credit score does not meet their criteria.
Disadvantages of short term finance
Following are some of the advantages related to short-term financing.
- Higher cost of interest – The lenders of the short-term loan charge a higher rate of interest. It’s because their income is limited to short tenure, and they need to make the most from it. Further, funds are disbursed immediately. Hence, the higher cost is associated with short-term financing.
- Revolving credit – Since the agreed length of the time expires soon. Hence, there is a need to actively monitor loan portfolios which may require more administrative resources.
- Low credit score – To raise finance via short-term financing, the business does not need a higher credit score. So, it’s a type of ease.
Examples of short term finance
Following are some of the examples of short term finance,
- Invoice discounting.
- Receivables discounting.
- Advance from customers.
- Line of business credit.
- Short-term loan.
Unsecured source of finance
The unsecured sources of finance are usually spontaneous/non-spontaneous that include followings,
- Accounts payable – It’s the amount payable to suppliers in the normal run of business (spontaneous).
- Accruals – It’s the amount that remains payable due to non-receipt of the bills/invoices (spontaneous).
- Market instruments – These are the instruments obtained from the money market.
- Bank loan – It’s the loan obtained from the bank/financial institution.
Importance of short term finance
Following is the importance of raising short term finance,
- It’s extremely important for the cyclical/seasonal businesses that need to ensure the availability of funds for the business.
- Sometimes, it can also be used to finance an emergency expenditure.
- Speed of raising finance makes it an excellent financing tool.
- It can be helpful for small businesses in times of economic downturn.
Audit procedures for short term financing
Following are some of the audit procedures performed to obtain assurance on the short-term finance figures in the financial statement.
- Review loan documents/contracts related to financing raise. It helps to ensure the existence of liability. Further, the bank statement can be reviewed to ensure receipt of the cash.
- Obtain a list of borrowings and reconcile it with the trial balance to ensure the balance of the borrowing in the financial statement. If there is any variance, it needs to be traced and reconciled.
- The loan balance/other details in the contract can be reconciled with the business’s financial statement, and it helps to ensure accuracy for the overall financial statement.
- Review financial statement notes to ensure all the significant information like interest rate and the terms have been disclosed in the financial statement.
Bottom line
Short-term financing refers to finance raised for not more than twelve months. It’s mostly raised by businesses to effectively manage the working capital requirements of the business. Further, it can be more important for businesses with cyclical/seasonal variations.
This type of financing can be spontaneous/non-spontaneous, depending on the source. For instance, the accounts payable and the accruals are spontaneous ways of financing. On the other hand, raising finance via bank loan is considered to be non-spontaneous.
Short-term financing is comparatively easy to obtain; the requirements for compliance and covenants are less stringent than the long source of finance. Further, short time finance is more flexible, easy to raise, and requires a higher credit score. However, the downside is that the related cost of the short-term financing is higher, leading to little compromise on the business’s profitability.
Frequently asked questions
Why do businesses use short-term finance?
The businesses use short term financing to,
- Meet working capital requirements.
- Manage seasonal/cyclical variations in business management.
What are the sources of business finance?
The sources of business finance include personal capital or savings, business angels, venture capitalists, commercial loans, buyouts, etc.
Provide names of the five sources of finance
- Retained earnings
- Bond issue
- A business line of credit
- Commercial loan
- Debentures
