Both debt and equity financing have a rightful place in small business finance. Financing with debt, a form of financing that includes loans, may be difficult when a business is just starting up. Instead, start-up businesses may have to rely on the owner’s savings or loans from friends or family for initial capital. After the business has operated for a year or more, the need for short-term business loans or other forms of short-term financing arises. Short-term loans are usually needed by small businesses for working capital needs. In addition to loans for working capital, other types of short-term debt financing exist for small businesses.
What Is Debt Financing?
Debt financing is money that a business owner borrows to operate a business. Debt financing occurs when a business owner seeks financing from a creditor or a lender. It is one broad category of small business finance and equity financing is another. Debt financing ranges from short-term loans from hometown banks to the smallest of businesses to long-term bond issues in millions of dollars for large businesses.
Debt Financing for Small Businesses by Maturity
Let’s look at the most common types of debt financing by maturity.
|Line of credit
|Merchant cash advance
Types of Short-Term Business Financing
- Trade Credit: A type of debt financing where the business seeks credit from other businesses who serve as their suppliers. The supplier usually extends terms to your business such as 2/10, net 30. This means that your business will get a 2% discount if you pay in 10 days, otherwise, the balance is due in 30 days.
- Short-term Loan: Business loans that have a maturity of one year or less. This means that they have to be repaid to the lender during that time. Small businesses more often need short-term as opposed to long-term business loans. Term loans with short maturities can help a business owner meet an immediate need for financing without requiring you to make a long-term commitment.
- Business Line of Credit: Gives the business continuous access to cash when needed. The business line of credit is generally unsecured by collateral and has favorable interest rates. In order for a business to obtain an unsecured business line of credit with favorable terms, it must have an excellent credit record. Usually, an unsecured business line of credit is obtained from a commercial bank and is designed to meet quick cash needs. No monthly payment is due until the business taps into the line of credit.
- Factoring: Uses a company’s accounts receivables to raise cash for short-term needs. Accounts receivable factoring is used when a business cannot qualify for a short-term business loan or unsecured business line of credit. Factoring is when a business sells its uncollected invoices to a third-party, which is called a factor, at a discount in order to raise money.
- Merchant Cash Advance: Uses a business’s credit card receipts as a type of collateral in order to make loans similar to paycheck cash advances for individuals. Merchant cash advances are generally only available to businesses that have a steady flow of credit card receipts. The interest rates are higher than for short-term bank loans and are more in the range of factoring. The maturity of the loans is very short-term.
What Are Short-Term Business Loans?
Small businesses most often need short-term loans instead of long-term debt financing. Businesses often prefer short-term loans over factoring or merchant cash advances which have higher interest rates and less favorable terms. This type of loan may also be easier to get than an unsecured business line of credit. The easiest type of business credit to get is usually trade credit.
Most term loans, classified as short-term, usually have a maturity of one year or less. They must be repaid to the lender within one year. Most short-term loans are often repaid much more quickly than that, often within 90 to 120 days.
Some business loans require collateral, but if you have been in business for more than one year and have good credit, you may not have to have collateral. In this case, a short-term business loan may be relatively easy to get.
How Can Short-Term Financing Help?
Short-term loans are often used to buy inventory for businesses whose sales are seasonal in nature. An example would be a retail business that has to build up inventory for the holiday season. Such a business might need a short-term loan to buy inventory well in advance of the holidays and not be able to repay the loan until after the holidays. That is the perfect use for a short-term business loan.
Other uses for short-term business loans are to raise working capital to cover temporary deficiencies in funds so you can meet payrolls and other expenses. You may be waiting for credit customers to pay their bills. You may also need short-term business loans to pay your own bills, for example, to meet your own accounts payable (what you owe your supplier) obligations. You may just need a short-term loan to even out your cash flow, particularly if your company is a cyclical business.
How to Qualify for Short-Term Financing
In order to qualify for a short-term loan or unsecured business line of credit, you will have to present comprehensive documentation to your lender, whether it is a bank, a credit union, the Small Business Administration, a mutual bank, or some other type of lender. The lender will want, at least, a record of your payment history for other loans you may have had, including payment histories to your suppliers (accounts payable) and your company’s cash flow history for perhaps the last three to five years. You should also be prepared to hand over your income statement for the same amount of time if the lender requests it. All documentation should be in a professional format.
Your lender will check your credit score and credit history through at least one of the three major credit bureaus. Your credit score may have to meet some minimum level.
Your qualifications will help determine whether or not the loan will be secured by collateral or whether it will be an unsecured, or signature, loan, or line of credit.
Short-Term vs. Long-Term Interest Rates
In a normal economy, interest rates on short-term loans are lower than interest rates on long-term loans. In a recessionary economy, however, short-term loan rates may be higher than long-term loan rates. The graphical representation of interest rates based on time and percentage is called the yield curve. Short-term loan rates are usually based on the prime interest rate plus some premium. The bank or other lender determines the premium by determining what risk your company is to them. They do this by looking at the documentation you provide them in order to qualify for short-term financing.
Short-term loan interest rates can be calculated in a number of ways. You want to get your lender to calculate the interest rate in the way most affordable to you.
As a business owner, be sure that you are knowledgeable about the current prime interest rate so you can talk intelligently to the bank loan officer as you negotiate the interest rate on your short-term loan.
Loans for Start-up and Small Businesses
Most start-up companies will only qualify for secured loans from a lender. In other words, the start-up firm would have to offer some sort of collateral to secure the loan with the lender. Seldom will a start-up qualify for a line of credit.
It is possible for a start-up company to secure a short-term loan. Start-up firms have to present extensive documentation to the lender, such as projected cash flow statements and sales forecasts for the next 3-5 years. They have to explain where their revenue will be coming from. The smallest of businesses often have to obtain loans from friends or family or take out loans against their home equity.
Equity financing, or financing with money from investors, has an important place in the financing of start-up companies. Sources from investments from family and friends to equity sources such as angel investors and venture capitalists are necessary for the success of start-up companies and U.S. economic success.
The availability of short-term financing to existing small businesses is absolutely essential in order for our economy to operate smoothly. Without short-term financing, small businesses literally cannot operate. They can’t buy their inventory, cover working capital shortages, or expand their customer base or their operations.