16.3 Obtaining Short-Term Financing

Sources and Types of Short-Term Financing

Short-term financing helps businesses cover immediate expenses and manage gaps in cash flow. Think of a retailer that needs to stock up on inventory before the holiday season but won't see revenue until customers actually buy. Short-term financing bridges that gap, with repayment typically due within one year.

Short-Term Financing Sources

Trade credit is the most common form of short-term financing. When a business buys goods from a supplier and doesn't have to pay right away, that's trade credit. Payment terms are usually 30, 60, or 90 days. For example, a supplier might offer "2/10, net 30," meaning you get a 2% discount if you pay within 10 days; otherwise, the full amount is due in 30. It's essentially a free short-term loan if you pay on time.

Short-term bank loans provide borrowed funds from a bank or financial institution, with repayment due in less than one year. Businesses use these for working capital, inventory purchases, or covering unexpected expenses. The bank charges interest, and terms are negotiated upfront.

Line of credit is a pre-approved borrowing limit you can draw from as needed. You only pay interest on the amount you actually borrow, not the full limit. This makes it flexible for managing unpredictable swings in cash flow. Think of it like a credit card for the business.

Commercial paper is an unsecured promissory note issued by large, financially strong companies. It's sold at a discount from its face value and matures within 270 days. Because only creditworthy firms can issue it, the interest rates tend to be lower than bank loan rates. Smaller companies generally can't use this option.

Factoring means selling your accounts receivable to a third party (called a factor) at a discount. The factor then collects payments directly from your customers. You get cash immediately instead of waiting 30, 60, or 90 days for customers to pay. The tradeoff is that you receive less than the full value of those receivables.

Unsecured vs. Secured Loans

• Unsecured loans don't require collateral. The lender relies on the borrower's creditworthiness and financial track record. Because the lender takes on more risk, interest rates are higher. Examples include unsecured lines of credit and commercial paper.
• Secured loans require collateral, which is an asset pledged as security (like inventory or accounts receivable). If the borrower defaults, the lender can seize the collateral. Because this lowers the lender's risk, interest rates are typically lower than on unsecured loans.

Short-Term Financing Costs

When choosing a financing option, businesses need to look beyond just the interest rate. Several types of costs factor into the decision:

• Interest expense is the direct cost of borrowing. It's calculated as: $\text{Interest Expense} = \text{Principal} \times \text{Interest Rate} \times \text{Time}$. For example, borrowing $50,000 at 6% for 6 months costs $50{,}000 \times 0.06 \times 0.5 = \$1{,}500$ in interest.
• Discount fee is the cost of selling commercial paper or factoring receivables. It's the difference between the face value and the amount you actually receive. If you factor $10,000 in receivables and the factor pays you $9,500, your discount fee is $500.
• Opportunity cost is what you give up by choosing one option over another. If you use available cash for short-term financing costs instead of investing in new equipment that could generate revenue, that lost potential return is your opportunity cost.
• Transaction costs include fees for arranging the financing: loan origination fees, legal fees, and appraisal fees (common with secured loans). These add up and should be included when comparing options.
• Effective Annual Rate (EAR) captures the true annual cost of borrowing by accounting for compounding and fees. The formula is: $EAR = \left(1 + \frac{r}{n}\right)^n - 1$ where $r$ is the nominal interest rate and $n$ is the number of compounding periods per year. EAR is useful because a loan that compounds monthly will cost more than one that compounds quarterly, even if both quote the same nominal rate.