To have a successful business, there needs to be a constant flow of any working capital. This is a vital component considering that outflow is going to be a part of each cycle; raw materials must be purchased; wages and salaries need to paid; equipment must be serviced; then funds are necessary for advertising, marketing, and other overhead costs as well as the needed reserves until a customer makes a payment. The lifeline of any business is going to be working capital.
One of the biggest questions asked is, “how does a company get those funds for working capital?”. The answer is financing, but there are two types – long-term and short-term financing.
Short-Term Financing meaning
Short-term financing represents a process when a company needs finances for only a short time, often under a year. The short term financing refers to trade credit, bank loans, and commercial paper. This may also be called financing for working capital.
This can be needed due to seasonal business patterns, uneven cash flows, etc. However, there are times when it will be used to finance accounts, receivable, inventory, etc. Yet, only single orders for a specific business will be financed.
There is an understanding of why this type of financing is needed. There are different sources to get this type of financing for companies. Each type will have a different type of character and may be used in various situations. Below, some of these types discussed:
Short term finance examples are:
- Short-Term Financing Trade Credit
This is a type of credit that will be extended by accounts payable. This can be often be split into two types, which are paid and free. After a certain amount of days based on the payment terms, suppliers will charge interest for payment delays. If the period happens to be free, once it is delayed, it becomes paid.
Free trade credit should be used as often as needed, simply due to it being free. How much can this cost? It actually depends on the buyer’s credit, payment history, business, etc. The higher that the rating is, the credit will be higher.
Paid trade-credit happens to be considered short-term, but it should only be used whenever other financing types are not available, and the reason is due to high-interest costs that come with it.
- Working/Short-term Capital Loans
You can get a working capital loan from a financial institution or bank. A bank will provide this type of loan after the business has been studied, and the cycle of working capital and the track record is looked at. Once it has been determined that it is available, these loans will have to have payments made in small payments or paid in full. This will be based on loan terms. It is best that these loans only be used when there is a need for a permanent capital.
- Line of Credit for Business
This is the form of financing that is best for temporary capital. Therefore, a set amount will be approved by a financial institution or bank when you use this type. Inside of credit line, a business can make a payment and then continuously deposit once the customer payment has made their payment. It is similar to using revolving credit. This means that the interest is only for what has been used but not on approved amounts. A business will be able to deposit any unused amount to keep interested low. This is seen to be the best way to be cost-effective when it comes to financing.
This type of financing is where any received invoices can be discounted through banks, financial institutions, or a third-party. This means that banks will pay the company when you discount the invoiced, and then it will collect payment from the customer whenever the invoice is due.
- Short-Term Financing Factoring
This type of financing is almost similar to discounting when an account would be sold to the bank at a lower price than the realizable value for the account. This particular type of purchase is called a factor. A person can get these services at a financial institution and bank. Various forms of factoring may be used as well, such as recourse, non-recourse, etc.
Another great thing to know is that banks will be a great source to gain working capital for short-term time periods.
- Short-Term Financing Overdraft Agreements
Whenever a business goes into overdraft agreements with banks, a bank will let the company borrow up to a set amount without any other discussion. However, a bank could ask for a type of security, and this could be collateral, or it could be interesting with variable rates on any outstanding amount. However, if a company believes that it can repay it quickly, then overdraft agreements will be useful for financing. This is a form that is often used by many businesses will go to.
- Financing on Accounts Receivable
Many non-banking and banking institutions will provide a way to provide financing to any accounts receivable. This means that the institution will purchase the bill and then collect amounts from customers. A company with large credit terms can continue doing business and not wait to get full payment from a customer.
- Customer Advances
Many businesses that state you have to pay before any services are provided, or goods are sold. This is a good thing, especially if it is a large order that could take a bit to fulfill. This also helps make sure that funds can be channeled into operations while the orders are being taken care of.
Some businesses, especially those that sell home appliances like stoves, refrigerators, televisions; businesses that sell electronics like computers, radios, etc., and the ones that sell cars, may allow customers to pay off their bill installments. Because most items are now considered essential, the customer may not be from a wealthy background and can afford an upfront cost. If that is the case, then there is no need to wait for large lump sums; the business will let the customer make small monthly payments until it is paid off. This helps make sure that regular funds are coming in and not choking up accounts receivable.
- Long-term Financing
One thing that many business owners need to know is that when a company relies on short-term amounts to be able to the needs of working capital, it will not always be the best thing, especially for an industry where it actually manufactures the product, which takes a bit of time to do like refrigerators, vehicles, computers, and aircraft. These companies are the ones that need to have working capital that will be able to be used for extended periods of time, and so they are the ones that often lean towards long-term financing.
- Long-term Loans
Some businesses will decide that they rather get a bank loan with long-term repayment options. This will allow the company to have the working capital needed for at least 3 years or more.
- Retain Profits
Instead of a business providing shareholders with dividend payments or even investing in something new, some companies will retain a certain amount of the profits that they make so that it can be used to create working capital. The businesses do this so that there is nothing to worry about taking out a loan, paying interest, taking a loss for discounted invoices, and being self-sufficient when it comes to financing.
- Debentures and Issue Equities
There will be some cases when a company is extremely low on funds. Whenever a business decides to invest in a new venture to expand, the business could decide to issue bonds or debentures to the public. There are cases where they could issue equity stock. Large conglomerates only do this, and it is only really used whenever a necessity for a lot of funds is required.
A company cannot always rely on certain limited sources to get working capital. Multiple options need to be used, and the company’s needs will always need to be evaluated. This can be done using an analysis of financial ratios and financial statements. The channel where working capital comes from needs to be selected carefully as it will be an ongoing process. Different types are various points in time may be more appropriate. The whole thing is for a company to select the right type of alternative based on the situation that they may have at that particular moment in time. Hopefully, this guide shines a light on what can be done by a company when meeting working capital needs.