Pros and Cons of Short-Term Financing for SMBs

Short-term financing can be a lifeline for small and medium-sized businesses (SMBs) looking to meet their immediate financial needs when cash flow is tight. Whether a business owner needs to stock the shelves or jump on an advertising opportunity, short-term financing could be the solution.

However, like any financing method, it has advantages and disadvantages that could sway a business owner one way or the other. In this article, we will delve into the pros and cons of short-term financing for SMBs, and explore some alternatives that businesses can consider.

Understanding short-term financing

Short-term financing is a crucial aspect of financial management for businesses. As the name suggests, it involves borrowing funds for a relatively short period, typically less than a year but potentially up to 18 months. Additionally, short-term financing amounts tend to be smaller compared with those provided by long-term financing, due to the shorter repayment period. 

Generally simple to qualify for, this quick type of financing is perfect for meeting the immediate financial needs of business owners, such as managing cash flow gaps, replenishing inventory, or funding short-term projects. On the flip side, short-term financing is not meant to facilitate major purchases, such as an expansion, investing in real estate, or a business acquisition, all of which generally require financing that is longer term in nature. 

Definition of short-term financing

Short-term financing transcends any one product. Instead, it is a financial strategy that helps businesses meet their immediate funding needs when the bank account balance is running low. It involves securing funds for a short duration, usually less than 12 months but up to 18 months on the longer side. 

This form of financing can be essential for businesses to bridge the gap between their cash inflows and outflows, ensuring smooth operations, financial stability, and peace of mind. It can make the difference between keeping vendors paid or ruining a relationship.

Short-term financing serves as a temporary solution to address immediate financial needs, like if a piece of equipment breaks down or severe weather causes damage to a storefront. It is commonly used to manage unexpected expenses, seize business opportunities like hiring talent, or fulfill short-term obligations.

By accessing short-term financing options, businesses can maintain their coveted liquidity while ensuring the doors will stay open and employees will be paid.

Types of short-term financing

There are several types of short-term financing that businesses can consider:

1. Trade Credit

Trade credit is a widely used form of short-term financing. It involves buying goods or services from a vendor today and deferring payment to a later date, typically within days or weeks. This arrangement allows businesses to acquire necessary resources without immediate cash outflow, providing them with flexibility in managing their finances. However, suppliers won’t just hand out trade credit to anyone–business owners must earn their trust first. When in doubt, think of Wimpy’s famous line from the Popeye the Sailor Man cartoon: “I’ll gladly pay you Tuesday for a hamburger today.”

2. Short-Term Loans

Short-term loans are another popular option for businesses to meet their immediate funding needs. These loans are provided as a lump-sum payment by financial institutions for a specific period, usually repaid within 12 months. Short-term loans may or may not require collateral, such as a vehicle or piece of real estate. They offer businesses quick access to capital, enabling them to address urgent financial needs or invest in short-term projects.

3. Line of Credit

A line of credit is a flexible financing option that allows businesses to borrow funds up to a predetermined limit. Unlike traditional loans, interest is charged only on the amount used, similar to a credit card. This form of short-term financing provides businesses with a safety net, ensuring they have access to funds on demand, without incurring unnecessary interest expenses.

4. Invoice Financing

Invoice financing, also known as accounts receivable financing, is a specialized form of short-term financing. It involves selling outstanding invoices to a lender in exchange for immediate cash, usually a percentage of the invoice value. This option helps businesses improve their cash flow by converting their accounts receivable into immediate working capital. However, before going this route, it’s important to let customers know that a third party might be communicating with them so there are no surprises. 

5. Merchant Cash Advance:

Merchant cash advances (MCAs) offer businesses a quick and unique funding solution. By providing a lump sum of capital upfront in exchange for a percentage of daily credit card sales, MCAs cater to immediate financial needs. Unlike traditional loans, payments are seamlessly aligned with daily cash flows, granting businesses flexibility. With rapid approval times and no stringent collateral requirements, MCAs stand out as a dynamic option in the short-term financing landscape. 

Each type of short-term financing has its own advantages and considerations. Businesses should carefully evaluate their unique needs and financial situation to determine the best option. By harnessing the benefits of short-term financing, businesses can ensure their financial stability and seize growth opportunities that might otherwise pass them by.

Advantages of short-term financing for SMBs

Improved cash flow

Cash is king, especially for business owners. One significant advantage of short-term financing is its ability to improve cash flow. SMBs often experience cash flow volatility due to delayed payments or unexpected expenses. Short-term financing provides a quick injection of funds to bridge these gaps and keep the business running smoothly.

Greater flexibility

Short-term financing options offer greater flexibility as compared to long-term financing. SMBs can tailor the loan amount and duration according to their specific needs. This nimble approach allows businesses to secure the necessary funds without being locked into long-term commitments.

Quick access to funds

When funds are needed yesterday, short-term financing can provide a quick solution. Unlike long-term financing, which may involve lengthy approval processes, short-term applications often have faster turnaround times, in some cases as quickly as 24 hours. This rapid access to funds can be crucial in seizing surprise business opportunities, keeping a competitive edge, or addressing urgent expenses such as a restaurant needing more help to meet a surge in demand.

Disadvantages of short-term financing for SMBs

Higher interest rates

Chief among the drawbacks of short-term financing is the potentially higher interest rates attached to these loans. Since lenders are shouldering additional risk with shorter repayment periods, they may charge higher interest rates to offset this risk. For example, annual percentage rates (APRs) on short-term business loans can range anywhere from 3% to 50% and up. Businesses must carefully consider the costs involved to ensure that the benefits of short-term financing outweigh the interest expenses and so they are not caught unaware.

Risk of over-reliance

While short-term financing can serve as a lifeline for immediate funding needs, it could also become too much of a good thing. Developing an over-reliance on short-term borrowing can lead to a vicious cycle of debt. Businesses should proceed with caution and only use short-term financing when necessary, instead of relying solely on it to keep the business afloat for the long-term. 

Potential for debt cycle

In some cases, businesses may find it challenging to repay short-term loans within the accelerated time frame. This can also result in a vicious debt cycle, with businesses constantly renewing or rolling over their short-term loans. Such a cycle can be detrimental to a company's financial health and hinder its long-term growth prospects.

Evaluating the suitability of short-term financing

Assessing your business needs

Before opting for short-term financing, it is crucial to assess your business needs. Consider the purpose of the funds, the urgency of the need, and the potential impact on day-to-day cash flow. Evaluate whether short-term financing aligns with your business goals and if alternative solutions may be more appropriate.

Weighing the costs and benefits

Consider the costs and benefits associated with short-term financing. Compare interest rates, repayment terms, and any additional fees or charges. Assess whether the benefits, such as improved cash flow or quick access to funds, outweigh the costs.

Alternatives to short-term financing

Long-term financing

For SMBs with greater financing needs, like opening a second location or renovating, long-term financing options may be more appropriate. Long-term loans, such as term loans or mortgages, provide businesses with higher amounts of capital to be repaid over longer periods of time. These loans often have lower interest rates compared to short-term financing, but they require a bigger commitment, with repayment terms ranging from three years to a decade or longer. It’s also common for long-term loans to require assets as collateral. 

Equity financing

Equity financing involves raising funds by selling shares in the company. This method can be beneficial for SMBs that have growth potential but may not qualify for traditional loans. Equity financing allows businesses to access funds without incurring debt, but here’s the rub: it also means sharing ownership and potential profits with investors.

The takeaway

In conclusion, short-term financing can provide SMBs with the capital needed to meet immediate financial needs, considering the ebbs and flows of cash flow. However, it is essential to carefully weigh the pros and cons before opting for this financing option. As part of doing their own research, SMBs should evaluate their unique situation, assess the suitability of short-term financing, and explore alternatives to make informed financing decisions. 

Revenue advances from Pipe are one option for small business owners seeking short-term financing. Pipe’s revenue advance is based purely on the revenue and health of the business and determined through secure, live data connections, so there’s no need for lengthy applications. You only pay for what you use, with flat, transparent fees paid over time, and payments are based on revenue to sync with your business’s cash flow. If you’re considering your options, you can learn more about how Pipe works, or sign up in minutes to find out how much capital you’re eligible for.