Almost every small business needs to borrow at one time or another. However, not all loans are created equal—and some types of finance are more appropriate in particular circumstances. So, what is the best guidance on a short-term loan?

All about short-term loans

As its name suggests, a short-term loan involves borrowing a fixed amount, with predictable repayments over anything from a few months to a couple of years. Typically, the sums borrowed are relatively small, which makes this type of loan easier to obtain than its long-term, high-value counterpart.

Of course, short-term loans aren’t suitable for every need. In particular, this is not the way to fund the purchase of a key piece of equipment that will give you service over many years. You’d do much better to spread the cost over a longer period or, if you can afford it, negotiate a cash discount.

One ideal application for a short-term loan is to address cash flow problems. If you’re struggling to pay your bills or tax, a short-term loan can offer a more cost-effective alternative to maxing out your business credit cards.

Similarly, a short-term loan can help you deal with seasonal downturns and upturns. The latter can actually be more damaging to your cash flow, as you will need to staff up and invest in raw materials to meet expected demand.

The same applies during periods of rapid growth: take on a major new customer and you’ll need to invest in people and equipment to service them weeks to months ahead of getting paid.

But what are the advantages and drawbacks of a short-term loan?

The pros

The best thing about a short-term loan is that you’ll soon be out of debt. Take on long-term borrowing and you could be facing a monthly drain on your finances for the next decade or more. Equally importantly, you’ll also pay a lot more total interest by spreading the cost.

A short-term loan can also be a quick way to build your credit score (assuming, of course, you repay on time and in full).

Finally, by taking out a short-term loan, you can avoid using a more flexible but much more expensive type of finance. These can include business credit cards, overdrafts and lines of credit, as well as more innovative solutions like merchant cash advances and invoice factoring and discounting.

If you’re not familiar with these financing methods, a merchant cash advance allows you to borrow an agreed sum and repay it via a fixed proportion of your daily credit card sales. The advantage, of course, is that you never need to make a substantial fixed payment during a quiet trading period.

Meanwhile, with invoice factoring and discounting you can borrow against the value of your invoices as soon as you issue them, with repayments being made when your customers pay you.

With factoring, the finance company assigns experienced credit control professionals to secure early payment, thus reducing your charges, whilst with invoice discounting you retain control of your own debtor ledger.

If these solutions sound like a godsend, they can be: in particular, invoice factoring and discounting can tame a troublesome cash flow for good and virtually eliminate the problems of late payers. However, you’ll almost certainly pay a good deal more than you would with a short-term loan.

The cons

However, it’s not all good news when it comes to short-term loans.

These types of loan tend to attract higher interest rates than their longer-term counterparts (though this doesn’t necessarily mean that the total interest cost will be higher—this depends as much on the term as the rate).

Your actual interest rate, of course, will depend on your credit score and your company’s financial circumstances. If you’re a start-up, you will pay a great deal more and may struggle to get the finance you need.

If you’re a proven and growing business with a solid credit score and a demonstrable record of profitability, you should be able to negotiate a competitive rate. Either way, you will obviously pay less if you secure the loan on an asset, though short-term loans tend to be unsecured.

It’s also important not to become addicted to this type of borrowing. Since short-term loans are easier to obtain than their long-term counterparts, and since almost every business hits a cash flow crisis now and then, it’s tempting to get into a cycle of borrowing and repaying—running to your bank or alternative lender for another short-term arrangement every time business takes a dip or a huge tax bill is looming.

If your company is experiencing these sorts of ongoing financial issues, you should look carefully at your expenditure and business terms (how quickly you pay your suppliers and how quickly you expect your customers to pay you) to see whether you can eliminate the problem at source.

If you can’t make any structural changes, you should consider alternative sources of finance rather than getting onto a treadmill of borrowing and repaying. As already mentioned, a line of credit—which offers you a fixed borrowing limit and allows you to draw down money and repay at will—may be more suitable for your needs.

Whilst this will attract a much higher interest rate, it’s important to remember that you pay only when you’re actually borrowing—whereas with many short-term loans there are substantial financial penalties if things go better than expected and you’re in a position to repay early.

Similarly, despite the potentially significant cost, invoice factoring or discounting could give you unrivalled peace of mind. Being able to claim around 85% of the value of your invoices, the instant you issue them, could be a game-changer for your company and make sleepless nights a thing of the past.

Opt for factoring rather than invoice discounting, and you won’t even need to maintain an accounts receivable team—the finance company will do everything for you.

Author: Carl Faulds, managing director of Cashsolv, provider of short term business loans to overcome cash flow problems. See how Cashsolv can help provide quick finance and ensure a positive future for your business.

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