For various reasons, many small businesses — even well-established ones — find themselves in need of a quick infusion of capital. This is especially true for firms that experience seasonal fluctuations or work on a contractual basis. With quick application processes and fast turnarounds, short-term lenders offer attractive solutions to businesses in a cash flow crunch.
However, while short-term loans can be a fruitful fix for some businesses, this type of finance doesn’t suit everyone. With the help of Philip Hargreaves, Head of Access to Finance at Growth Hub, our article will walk you through the three steps to wisely financing your business with a short-term loan.
1. Understand short-term loans
A short-term business loan is defined as a loan with a maturity of one year or less. However, the brunt of short-term loans tend to be repaid faster than this — typically within 90 to 120 days. While short-term loans can serve a range of purposes, generally, they are most commonly used to boost a business’s working capital levels. Short-term loans tend to have higher interest rates than their long-term counterparts.
“There’s a conception that if a business has short-term cash needs it’s in trouble,” says Philip. “Of course, while this is true in some cases, a lot of small businesses are looking for capital injections to manage fast growth or to finance a business opportunity.”
Short-term business loans — especially those offered by alternative lenders and fintech companies — have seen impressive growth in recent years. According to one estimate, the amount of short-term credit loaned by non-bank lenders doubled between 2012 and 2013, from nearly £1.1 billion to just over £2.1 billion. The growth of the alternative lending industry is partly driven by the fallout of the 2007 financial crisis, when banks began slowing down small business lending.
“Fintech and alternative finance is supporting the maturity of the short-term industry,” Philip says.
“Short-term lending has grown up from simply being a bridging solution.”
2. Analyse your business’s needs
A short-term loan isn’t right for every business. In some cases, it can even be counterproductive or damaging. Before applying for a short-term loan, it’s important to work out the purpose of the prospective loan, as well as your business’s longer term needs.
“Short-term loans suit growing businesses that need an immediate boost of cash,” Philip explains. “These businesses may need more working capital to gear up towards a new contract, or to take on additional staff to cope with workload.” Short-term loans are a good option for businesses that need fast capital injections and know they are able to repay the loan reasonably quickly. For example, businesses that are preparing for their busy season to kick in.
Purchase inventory before a busy period
If you run a seasonal business, like a beachfront hotel, you may need to buy extra stock and equipment to prepare for the busy summer period. A short-term loan allows you to buy the products you need to meet the spike in demand. In this scenario, the loan can be repaid quickly as revenue increases.
Some experts recommend using the principle ‘don’t finance long-term needs with short-term money’. Essentially, this means not using short-term credit to fund bigger business needs, like significant equipment upgrades or purchasing commercial property.
Avoid buying fixed assets
“Kit or equipment might be better financed over its life cycle, rather than through a short-term loan,” Philip recommends. “Similarly, long-term assets like real estate shouldn’t be financed with short-term loans.” Matching up the lifetime of an asset with the term of a loan is a basic principle that should always be considered.
As every business owner knows, sometimes the unexpected happens. A short-term loan can keep things moving by financing an urgent repair.
Make a vital repair
In a similar vein, if your hotel’s cooking equipment breaks down, your business is in serious jeopardy. A short-term loan lets you pay for a repair upfront and spread the cost of the work over a couple of months.
“While short-term loans can be fast and simple, they’re not always the right option,” Philip warns. “Businesses considering taking out credit should always have a longer term view on income.”
“If you anticipate income levels to grow and rise, a long-term loan is easier to spread over time.”
3. Weigh up the pros and cons
When comparing long and short-term loans, consider factors like the price of the loan, as well as how much time you have to spend on the application process and if you are willing to offer the lender collateral. In terms of interest rates, a bank loan will nearly always be cheaper than a short-term loan. However, an application could take weeks or months to complete. A traditional lender may also require you to secure the loan with an asset, like inventory or real estate. The valuing an asset can further prolong the application process.
Work out the opportunity cost of not accessing finance. For example, calculate the amount of sales you will lose if you don’t use a loan to buy some discounted inventory (strawberry ice cream, perhaps). If the sum is greater than the (total) cost of the short-term loan, it might make commercial sense to take out the loan.
While business financing isn’t an exact science, following some basic principles will help you make the most prudent decisions for your small business. Both short and long-term loans are useful financial products, and it’s a business owner’s responsibility to invest time in working out which one fits their needs. However, don’t be afraid to reach out to an expert. As Philip says:
“Finance your needs in the right way and with the right advice.”
Originally published February 12 2018 , updated March 14 2018