If you are operating a small business and are struggling with cash flow problems, I am sure you would be looking for someone to lend you some capital. The first idea that would have crossed your mind was going to your local bank and ask them for a loan. After meeting with the representative from the bank, he would have offered you the terms on which they will lend you the money, but it is too costly for you to afford. The next thing you do is ask your friends to help you find alternatives, and some suggest you avail the facility of short-term financing.
Short term financing allows you to get business loans and pay them back quicker compared to traditional bank loans, although the interest rates are higher. After talking with the lender, you feel that the terms are favorable, and you want to sign the deal. However, there are certain risks involved which you need to be aware of before you go signing the documents. Read on to see some risks stated below.
1. Renewal Problems:
If for some reason, you fail to pay back the loan at the given deadline, the lender has the power to renew your contract on terms which may be unfair for you. Since you are the borrower, there is nothing you can do about the specific details about the agreement and the renewed repayment plan. Some of these terms are harsh enough to force the business to declare bankruptcy. Hence it is essential to remember that the only reason you are borrowing money is that you want to solve the cash flow problems. It will help you to decide whether the loan is worth taking or not since it can cause problems for your business in the long term.
2. High Rates of Interest:
If you go to a bank and inquire about what is short term financing and ask about the interest rates, you will realize that the problem with short-term loans is that the escalated interest rate charged is high when compared with long term loans. Such businesses end up paying more money in the long run than if they had decided to negotiate with the lender for a bigger loan. Such scenarios can harm a small business that is already struggling to survive. Although the process of receiving funds is quick, the annual costs are still high for the majority of the firms which are operational for the past 1-2 years. Another point to remember is that in traditional loans, the factor rate decreases when the principal amount gets lower. It is not the case in short term loans, where the factor rate remains constant throughout your loan deal.
3. Risk of Reputation:
The reputation of your business is on the line when you decide to avail of the option of short-term financing. The reason behind this is that investors will not have a favorable opinion about your firm if they feel that your company is heavily relying on short-term loans. It gives off the impression that your company is struggling to survive, which can have adverse consequences for you. Investors want to invest their money in a company that can give them profits and failure of payment will affect your credit score which may cause trouble for you if you want to take a long term later on.
4. Low Capital Involved:
Loans issued for a short period have less money involved. The amount of money you borrow is usually small enough for a business to pay off within a few months or years. A sum may solve cashflow liquidity problems and cover low expenses such as rent and bills but will not help you to purchase new inventory or restart production in case you need to meet a deadline. Loans such as these may help you to escape from a crisis, but it will not be useful if you want to use the money for expansion purposes.
5. High Scrutiny:
Short term loans are unsecured meaning that they do not look at credit scores when giving out loans. Considering this, the risk of default is significant, and the borrower might end up losing his or her money. Thus, the credit history of the borrower is scrutinized heavily by the lender and if the lender feels that the borrower might not give you the loan. It might have dire consequences for your business if you were dependent on that loan to help you meet your financial obligations.
6. Number of Payments are High:
While in long-term financing, you are usually asked to make monthly payments. It is not the case when you apply for a short-term loan where you have to make weekly or sometimes daily payments. These payments at such short intervals can be tough to establish if there is a liquidation problem in your cashflow. In such a scenario, a week of low business will leave you with a series of penalties, and even at the risk of being a default. If your business is already used to get late payments, you should review your payment schedule before deciding to agree to a short-term loan. You should not get involved in a debt cycle where you are taking new loans to pay off the primary loan you already cannot afford.
Like everything else, short-term financing comes with its pros and cons. Although it can get tempting many a time, it is not always the best option for every small business owner to take. Large businesses can afford such loans since their revenues are high, but these loans can force you to close off your business if you are unable to pay off the loans on time. It is worth remembering that such investments are worthy only if you need quick cash which can put you in a favorable position, or you want money when the business is undergoing a temporary slump. In such cases, you should talk to multiple lenders to get the best deal when you decide to go for a short term financing loan.