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To have a successful business, there must be a constant flow of 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 be paid; equipment must be serviced; then funds are necessary for advertising, marketing, and other overhead costs as well as the required 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?”. Of course, the answer is financing, but there are two types – long-term and short-term funding.
What is Short-Term Financing?
Short-term financing refers to borrowing or raising funds to meet the short-term financial requirements of a business or an individual. Typically, short-term funding covers expenses or investments that will be repaid or settled within a year or less.
Short-term financing options include:
- Trade Credit refers to the credit suppliers extend to customers for purchases made on credit. The credit period usually ranges from 30 to 90 days.
- Bank Overdraft: A bank overdraft allows an individual or business to overdraw their account up to a specific limit agreed upon with the bank. The interest is charged only on the amount overdrawn and for the period the account is overdrawn.
- Short-term Loans: These are loans taken out for up to one year, with the loan amount and interest to be repaid by a specific date.
- Factoring: This is selling accounts receivable to a financial institution at a discounted rate to receive immediate cash.
- Commercial Paper: This is an unsecured promissory note issued by a company to raise short-term funds. The maturity period for a commercial paper usually ranges from 1 to 270 days.
Short-term financing is generally easier to obtain than long-term financing, as the amount borrowed is smaller and the repayment period is shorter. However, it typically comes with higher interest rates than long-term financing options.
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, receivables, inventory, etc. Yet, only single orders for a specific business will be funded.
Trade credit short-term financing example
Suppose a small retail store orders $10,000 of merchandise from a supplier. Instead of paying for the merchandise upfront, the supplier offers a trade credit of 30 days, meaning that the retailer can pay for the merchandise 30 days after receiving it.
The retailer accepts the trade credit and receives the merchandise. They then sell the merchandise to customers and generate revenue from the sales. After 30 days, the retailer pays the supplier $10,000 for the merchandise.
In this example, the retailer used trade credit as short-term financing to purchase merchandise without paying it upfront. This allowed the retailer to generate revenue from the sales before paying for the inventory, which helped to improve their cash flow and liquidity.
Trade credit is a common form of short-term financing widely used in many industries, mainly retail and manufacturing. It can provide a convenient and flexible way to finance short-term purchases.
Bank Overdraft short-term financing example
Let’s say that a small business is experiencing a temporary cash-flow shortage and needs to pay $5,000 to a supplier within the next few days. However, the company only has $3,000 in its checking account.
The business owner contacts their bank and arranges a bank overdraft of $2,000, with an interest rate of 10% per annum, to cover the shortfall. The bank approves the overdraft, and the business owner can now make the $5,000 payment to the supplier.
Over the next few days, the business receives customer payments and deposits them into their checking accounts, which helps reduce the overdraft balance. After three days, the company has deposited $3,000 into its history, leaving a remaining overdraft balance of $2,000.
At the end of the month, the bank calculates the interest on the overdraft balance of $2,000 for the three days that it was outstanding. The interest charge is $1.37 ([$2,000 x 10%] ÷ 365 days x 3 days).
In this example, the business used a bank overdraft as a form of short-term financing to cover a temporary cash-flow shortage. The overdraft allowed the company to make the necessary payment to the supplier and repay the amount over a short period, with interest. Bank overdrafts are a common form of short-term financing that many businesses use to manage their cash flow and cover unexpected expenses.
Short-term Loans Short-term finance example
Let’s say that a small business needs to purchase new equipment to expand its operations. The kit costs $20,000, but the company only has $10,000 in available cash.
The business owner decides to apply for a short-term loan of $10,000 to cover the remaining cost of the equipment. They apply for the loan at a local bank, which approves the loan with a repayment period of six months and an interest rate of 8% per annum.
The business owner uses the loan to purchase the equipment and begins using it to generate revenue. Over the next six months, the business makes regular payments of $1,725 ($10,000 loan principal + $400 interest ÷ 6 months) to the bank to repay the loan.
At the end of the six months, the business had successfully paid off the loan, and the equipment helped to boost the business’s operations and revenue.
In this example, the business used a short-term loan as a form of short-term financing to purchase the equipment needed to expand its operations. The loan provided the necessary funds to buy the equipment, and the business could repay the loan over a short period. Short-term loans are a common form of short-term financing that many companies use to finance specific projects or purchases.
Factoring Short-term finance example
Let’s say that a small business provides a service to a customer who agrees to pay $20,000 for the service within 60 days. First, however, the company needs immediate cash to cover its operational expenses.
The business owner decides to sell the outstanding invoice to a factoring company for a discounted $18,000, receiving immediate cash of $16,200 (90% of the invoice value). The factoring company takes over the responsibility of collecting the payment from the customer.
After 60 days, the factoring company collects the entire $20,000 from the customer. It pays the remaining $1,800 (10% of the invoice value) to the business minus a factoring fee of $200 (1% of the invoice value).
In this example, the business used factoring as a form of short-term financing to generate immediate cash flow by selling the outstanding invoice to a factoring company. As a result, the firm received cash upfront to cover its operational expenses, while the factoring company assumed the responsibility of collecting the payment from the customer. Factoring is a common form of short-term financing used by businesses with outstanding invoices that need immediate cash.
Commercial Paper Short-term finance example
Let’s say that a large corporation needs to raise $2 million in short-term funds to cover its working capital requirements. So the corporation decides to issue commercial paper, an unsecured promissory note with a maturity period of 180 days and an interest rate of 5%.
The corporation issues the commercial paper to institutional investors, such as mutual and pension funds, who purchase the notes at face value. The investors will receive interest payments every 90 days, and the corporation will repay the principal amount of the commercial paper at maturity.
Over the next 180 days, the corporation uses the funds raised through the commercial paper to finance its working capital requirements, such as paying suppliers, covering payroll expenses, and investing in new projects.
After 180 days, the corporation repays the principal amount of the commercial paper, totaling $2 million, to the investors. As a result, the investors have received $50,000 in interest payments ($2 million x 5% annual interest rate ÷ 2), and the corporation has met its short-term funding requirements.
In this example, the corporation used commercial paper as short-term financing to raise funds to cover its working capital requirements. The commercial paper provided a flexible and convenient way for the corporation to obtain short-term financing, and the investors could earn a competitive return on their investment. Commercial paper is a common form of short-term financing large corporations use to raise funds quickly and efficiently.