When Does Short-term Debt Make Sense?

There’s a reason why the old phrase “you have to spend money to make money” is so prevalent—because access to capital is the lifeblood of any business, and small businesses in particular.

This concept is never more apparent than when a company is on the verge of an exciting revenue-generating opportunity, but can’t make it work because it lacks the funds. Watching guaranteed profits disappear is a helpless feeling.

But there’s an option available to businesses that need money for inventory fulfillment, expansion, operational expenses, or startup costs: taking short-term debt on in return for funding. The short-term business loan model has seen extraordinary growth in recent years—non-bank short-term lenders doubled the amount of money they loaned between 2012 and 2013, from $1.5 billion to $3 billion.

This alternative lending model helps meet the demands of an underserved group, especially after tightened lending standards that emerged in the wake of the 2008 Financial Crisis locked many small businesses out of the credit market. According to the Wall Street Journal, the value of all outstanding small commercial loans (under $1 million) at federally-insured banks declined by 15% between 2007 and 2013.

To qualify for a loan from a big bank, small businesses need to have an iron-clad credit score, provide tax returns, business plans, and other documentation, and then wait several weeks for a decision. And in the end, big banks hand out loans to a mere 18% of applicants—while on the other hand, non-bank lenders approve of 49% of applicants.

Short-term lending isn’t a solution that fits every situation, since the interest attached to these loans is considerably higher than most conventional options. But for businesses looking for an ultra-fast lending agreement with relaxed credit and documentation requirements, taking on short-term debt might be the best possible choice.

When Short-term Debt Makes Sense

There are certain situations where securing a short-term loan might be the best move.

Scenario 1

Your business has a revenue-creating opportunity lined up but doesn’t have the capital to see it through. This might involve a large pending order for a buyer that you can’t fill right now, a seasonal sales push during the holidays, or essential equipment or inventory you need to buy for your startup.

Because this revenue depends on securing additional capital, going into short-term debt makes perfect sense. Once you secure that extra revenue, you can repay your short-term debt off, letting the business turn a quick profit with little risk.

Scenario 2

The nature of the business is important when considering short-term debt. Enterprises that generate daily revenue are well-suited for this lending model, as most short-term loans are automatically repaid through daily ACH transactions.

While this payment schedule works well for firms that earn steady revenue, businesses reliant on a handful of clients who pay weekly or monthly could have a more difficult time dealing with daily repayments. Generally speaking, short-term debt should be restricted to assets that can bring in revenue quickly, like inventory, while long-term loans should be for long-term assets, like property.

Scenario 3

It’s also important to realize that short-term loans typically don’t amortize like conventional loans. As a result, it’s often difficult to discern whether you’re paying interest or principal. If you want to pay off a loan early, short-term lenders will usually provide a flat discount on the remaining balance. The small number of short-term lenders who do amortize might forgive any remaining interest or allow businesses to pay a percentage of that interest. Terms vary between lenders, so it’s important to rigorously investigate pre-payment terms before entering a contract.

The Benefits of Short-term Loans

If you’ve found yourself in a situation where a short-term loan might make sense, here are several key reasons to consider moving forward.

Availability

Short-term lenders typically have more relaxed eligibility requirements than conventional bank or SBA loans do. This lets borrowers with damaged credit access much-needed sources of capital. For businesses shut out of the conventional lending market, short-term debt are often a lifeline.

Speed

Businesses with immediate capital needs can usually secure short-term loans in a matter of hours, not days. This stands in stark contrast to many conventional lenders, who often take weeks or months to close a deal.

Limited Duration

Short-term loans are, by definition, of limited duration, typically somewhere between 3 and 18 months. This means your short-term debt quickly gets cleared off your books, which is always comforting.

Easier to Qualify For

Documentation requirements are much looser—often just a few months’ worth of bank statements. Busy business owners, or anyone who’s been through the arduous process of securing traditional bank financing, will appreciate this difference. By securing capital through a streamlined process that requires minimal paperwork, business owners can focus on day-to-day operations, instead of getting bogged down in financing details.

Is Short-term Debt Right For Me?

No two situations are exactly alike, so every business owner has to answer this question for herself. Considering that roughly 50% of businesses don’t survive longer than five years, it goes without saying that every small business owner should weigh the pros and cons of taking out a loan.

Also, you should keep in mind these top 5 predictive indicators of business loan defaults:

• Your cash-to-assets ratio is low
• Your EBITDA-to-assets ratio is low (EBITDA = earnings before interest, taxes, depreciation and amortization)
• Your EBITDA-to-long-term-debt is low
• Your liabilities-to-assets ratio is high
• Your net income-to-sales ratio means low profits

But there are some yardsticks you can use to determine if a short-term loan is a savvy choice.

If you’re in a position where failing to secure new capital will cost your company guaranteed revenue, a short-term loan is almost always a good choice. The money can be paid back quickly, with little-to-no risk. Using a short-term loan to refinance other short-term debt at a better rate is also a smart move.

On the other hand, taking out a short-term loan to meet long-term debt obligations (the old “robbing Peter to pay Paul” scenario) is less defensible. In general, short-term loans are best suited for situations where they can be directly tied to revenue.

It’s important, however, to always compare a range of loan offerings in order to determine the option that best fits your borrowing needs.

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from Fundera Ledger https://www.fundera.com/blog/2016/01/07/short-term-debt/