Is a Short-Term Business Loan a Good Idea?

When cash flow gets tight and owners have a hard time paying their bills, the knee-jerk reaction can be to get short-term business loans.

What Is a Short-Term Business Loan?

Typically a short-term business loan is an injection of cash into a company that lasts for less than a year. This may be a result of seasonal trends or investments that need to be made ahead of revenue realization.

Owners need to be careful since many short-term business loans can have high interest rates that need to be paid back in less than a year. If they can't pay it back in time, the loan may eventually hurt their cash flow.

Whether or not taking out a short-term business loan is a good idea depends on what the loan will be used for in a company.

Benefits of Short-Term Business Loans

Using short-term business loans can be beneficial, if, in the next year, investing that cash can actually make you money.

For example, if your company’s sales are seasonal and you need to buy inventory to stock up for a busy sales season, the money from the loan can generate revenue. Even if you must pay 15-percent interest on the short-term business loan, if you have a 50-percent gross margin on sales, this will allow you to pay back the loan and still make a profit.

Another good reason for short-term small business loans is to buy a piece of equipment or hire sales staff that will generate profitable revenue in the next year.

Drawbacks of Short-Term Business Loans

Short-term business loans can hurt the company when they are used to fill a cash-flow hole left by financial losses. The problem here is that once that new cash-flow infusion runs out, the company is still left with more losses and cash shortages.

Unless the new short-term business loan will fundamentally change the financial metrics of the business, I wouldn’t advise taking one out since it can plunge a business owner deeper into debt—and it doesn't provide a long-term solution.

Another signal that a short-term business loan isn't a good idea is if your current ratio (current assets divided by current liabilities) is less than zero. It may demonstrate your inability to have free cash flow to pay the loan back.

Where to Find Short-Term Business Loans

When you're looking into short-term business loans, make sure to match the right loan to your company's needs. Before acquiring a short-term business loan, remember that any loan that can’t be paid back within terms can further hurt the company. If you feel that this cash infusion will be beneficial, identify what it will be used for and when there will be cash flow to pay it back.

Here are a few areas where you can find short-term business loans:

Trade Credit

Ask your vendors for more time to pay your bills. This can be the cheapest place to get interest-free money while giving you more cash to fund other initiatives.

A short-term business loan can be an effective financing tool for many companies, but the type of loan needs to match why the cash infusion is needed.

Let's say every month you buy $5,000 worth of product or services from a vendor, and they give you 30 days to pay. Since there is always a payment due in the future for $5,000, there's $5,000 that you effectively never have to pay this vendor as long as you keep buying the same amount from them. These funds can then be used for other expenses. (Of course, if you end your relationship with this vendor or reduce the amount you buy from them, the final payment eventually needs to be made.)

When to use this: Asking for better payment terms is always a good idea. The worst they can say is no.

Family and Friends

While this can have personal consequences, getting short-term business loans from friends and family is inexpensive and usually provides payment flexibility. These types of loans usually carry very little interest, but if you are unable to pay it back, it can damage personal relationships.

When accepting a loan from family and friends, always document the loan rate and repayment plan in a written document to manage expectations from both borrower and lender.

When to use this: Not sure if you can pay a short-term business loan back on time and need flexible payment terms? A family and friends loan can be a good option.

Accounts Receivable Factoring

This short-term business loan turns your customer invoices into cash without you having to wait for them to be paid. In many arrangements, you can get 85 to 90 percent of the outstanding invoices. (Additional fees can be added if the customer does not pay within terms.)

When to use this: Accounts receivable factoring can be beneficial if a company’s receivables are growing rapidly and cash needs to be invested immediately to help produce a significant increase in sales.

Bank Overdraft

Many financial institutions provide an overdraft feature on a business account so the company can draw more cash than they have in the bank. This overdraft is then turned into a line of credit that needs to be paid off shortly after.

When to use this: This is beneficial if the short-term business loan can be paid off in less than a year and is not needed as permanent working capital.

Credit Cards and Advances

Credit card companies increasingly provide working capital loans for owners to finance their business. Many financial institutions offer introductory or balance transfer rates that can carry a lower interest rate for six months to a year.

When to use this: Same as with a bank draft, this can be used when the loan can be paid off in less than a year and isn't needed as permanent working capital.

Online Loan Brokers

Many companies now offer business loans that are personally guaranteed by the owners on a short-term basis. Rates can be 12 to 50 percent annually. On these sites, companies apply for a certain loan amount and then get approved for a rate. Money is borrowed from the broker.

When to use this: If the cash infusion can produce significant revenue in the next year to pay off the short-term business loan, online loan brokers may be an avenue worth exploring.

Crowdsourcing

There are internet platforms that connect borrowers with private lenders. Rates can be as low as 10 percent APR. On platforms like Prosper and Lending Club, businesses post their projects and company history for individual lenders to submit bids on how much they will lend at a specified rate.

When to use this: If a company can qualify for these loans, they can find lower rates from individual lenders and the terms of payoff may be longer.

A short-term business loan can be an effective financing tool for many companies, but the type of loan needs to match why the cash infusion is needed. If this is not done, it can place the company into further debt and actually be harmful to its future.

Read more articles on short-term financing.

Photo: Getty Images

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