When you're just starting a new business, debt financing—a form of financing that includes bank loans—may be difficult to. Instead, you may have to rely on your own savings or investments from friends or family for initial capital.
After you've been in business for a year or more, you may be able to get short-term business loans or other forms of short-term financing arises. Short-term loans are usually needed by small businesses for working capital. In addition to loans for working capital, other types of short-term debt financing exist for small businesses.
- Debt financing is often needed to even out cash flow, buy inventory, cover emergency expenses, or take advantage of new opportunities.
- Types of debt financing for small businesses include trade credit, short-term loans, lines of credit, factoring, and merchant cash advances.
- Trade credit is often the easiest form of debt to get; short-term loans are much harder, but are more flexible.
What Is Debt Financing?
Debt financing is money that a business owner borrows to operate a business. Debt financing occurs when a business owner seeks financing from a creditor or a lender. It is one broad category of small business finance and equity financing is another. Debt financing includes small, short-term loans from hometown banks, as well as long-term bond issues worth millions of dollars for large businesses.
You may need debt financing to
Debt Financing for Small Businesses by Maturity
Let's look at the most common types of debt financing by maturity.
|Trade credit||Mezzanine financing||Long-term bonds|
|Short-term loan||Intermediate-term bonds||Mortgages|
|Line of credit||Intermediate-term loans||Debentures|
|Merchant cash advance|
Types of Short-Term Business Financing
- Trade Credit: A type of debt financing where the business seeks credit from its suppliers. This is often the easiest type of business credit to get. The supplier usually extends terms to your business such as 2/10, net 30. This means that your business will get a 2% discount if you pay in 10 days. Otherwise, the balance is due in 30 days.
- Short-Term Loan: Business loans that have a maturity of one year or less. This means that they have to be repaid to the lender during that time. Small businesses more often need short-term as opposed to long-term business loans. Term loans with short maturities can help a business owner meet an immediate need for financing without requiring you to make a long-term commitment.
- Business Line of Credit: Gives the business continuous access to cash when needed. The business line of credit is generally unsecured by collateral and has favorable interest rates.
In order for a business to obtain an unsecured business line of credit with favorable terms, it must have an excellent credit record. Usually, you get an unsecured business line of credit from a commercial bank and it's designed to meet quick cash needs. No monthly payment is due until you tap into the line of credit.
- Factoring: Uses a company's accounts receivables to raise cash for short-term needs. Accounts receivable factoring is used when a business cannot qualify for a short-term business loan or unsecured business line of credit. Factoring involves a business selling its uncollected invoices to a third party, which is called a factor, at a discount in order to raise money.
- Merchant Cash Advance: Uses a business's credit card receipts as a type of collateral in order to make loans similar to paycheck cash advances for individuals. Merchant cash advances are generally only available to businesses that have a steady flow of credit card receipts. These types of loans often have high APRs. The maturity of the loans is very short-term.
Because of the short-term nature of merchant cash advances, their fees, when converted to an annual percentage rate, often make them the most expensive form of financing for a small business.
What Are Short-Term Business Loans?
Small businesses often need short-term loans instead of long-term debt financing. For short-term financing, loans are usually preferable to factoring or merchant cash advances, which have higher interest rates and less favorable terms—though those are usually easier to get than an unsecured loan.
Many business loans require collateral, though SBA 7(a) small loans under $25,000 don't require lenders to secure collateral from borrowers.
How Can Short-Term Financing Help?
Short-term loans are often used to buy inventory for businesses whose sales are seasonal in nature. An example would be a retail business that has to build up inventory for the holiday season. Such a business might need a short-term loan to buy inventory well in advance of the holidays and not be able to repay the loan until after the holidays. That is the perfect use for a short-term business loan.
Other uses for short-term business loans are to raise working capital to cover temporary deficiencies in funds so you can meet payrolls and other expenses. You may be waiting for credit customers to pay their bills.
You may also need short-term business loans to pay your own bills; for example, to meet your own accounts payable (what you owe your supplier) obligations. You may just need a short-term loan to even out your cash flow, particularly if your company is a cyclical business. Or you may want to take advantage of a business opportunity, like entering a new market that requires investing in more staff or supplies.
How To Qualify for Short-Term Financing
In order to qualify for a short-term loan or unsecured business line of credit, you will have to present comprehensive documentation to your lender, whether it is a bank, a credit union, a mutual bank, or some other type of lender.
The lender will want, at least, a record of your payment history for other loans you may have had, including payment histories to your suppliers (accounts payable) and your company's cash flow history for perhaps the last three to five years. You should also be prepared to hand over your income statement for the same amount of time if the lender requests it. All documentation should be in a professional format.
Your lender will check your credit score and credit history through at least one credit bureau. Your credit score may have to meet some minimum level.
Your qualifications will help determine whether or not the loan will be secured by collateral or it will be an unsecured, or signature, loan or line of credit.
Loans for Start-Up and Small Businesses
Most start-up companies will only qualify for secured loans from a lender. In other words, the start-up firm would have to offer some sort of collateral or a personal guarantee to secure the loan with the lender. Seldom will a start-up qualify for an unsecured loan or line of credit. Many start-ups have to obtain loans from friends or family or take out loans against their home equity.
Equity financing, or financing with money from investors, has an important place in the financing of start-up companies. Sources from investments from family and friends to equity sources such as angel investors and venture capitalists are often necessary for the success of start-up companies, especially those in the technology or biotechnology sectors.
Frequently Asked Questions (FAQs)
How does short-term financing help a business?
You can use short-term financing to even out cash flow, buy inventory, or take advantage of an opportunity like investing in a new product or market. You may also need a loan for one-off emergency expenses.
What should I consider in a short-term loan?
When considering whether to take out a loan or not, consider what you need the money for, whether you'll really be able to pay it back, and whether the cost of borrowing is worth it—especially if you have other options. If you decide you do need a loan, think about how much you need, how quickly you need the money, the types of financing you can qualify for, and the total cost of each.
Federal Deposit Insurance Corporation. "Fueling Your Business: A Guide to Financing Your Small Business," Page 6-10. Accessed June 20, 2020.
CDC Small Business Finance. "Want To Get an Online Business Loan? 10 Questions To Ask Before Committing to One." Page 3.
U.S. Small Business Administration. "Types of 7(a) Loans."
OnDeck. "Your Guide to Short-Term Financing," Pages 10-12.