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Short Term Financing – Characteristics, Advantages and Disadvantages | Corporate Finance

Short Term Financing

Meaning of Short-Term Financing

Short-term financing consists of all those liabilities that are originally scheduled for repayment within one year. Short-term financing is used to finance the working capital of the firm. The firm uses this short-term financing to enhance its operating efficiency of the firm. The funds from short-term financing are used to cover day-to-day expenses such as the purchase of raw materials, salary, wages, etc.

The requirement of short-term financing depends upon the nature, goal, and operation of the firm and the selection of sources of funds depends on respective risk, maturity periods, cost, and provisions for the respective financing sources. Here, Short term financing is all about selecting the sources of funds that have the lowest cost and risk and fits the firm’s policy as well. Different short-term financing sources are evaluated based on the respective cost and requirements of the firm.

Characteristics of Short-Term Financing

Characteristics of Short-Term Financing

Important characteristics of short-term financing are as follows:

  • Short-term financing may be the least costly or most costly or cost-free.
  • Short-term financing is more flexible than long-term financing in terms of amount raising and repayment.
  • Short-term financing can be obtained faster than long-term financing.
  • Short-term financing needs not collateral or security.
  • Short-term financing is riskier than long-term financing because the default in payment may create legal problems.
  • Short term financing is less restrictive than long-term financing
  • Short-term financing is used to increase the current assets to increase the working capital of the firm.

Short-term financing has its own merits and demerits. 

Advantages of Short-Term financing

Advantages of Short-Term financing

Some of the merits of Short Term Financing are as follows:

  • Less Costly: Some short-term financing is cost-free i.e. trade credit and has less flotation cost compared to other sources of financing.
  • Low covenants: Some short-term financing has zero covenants and some short-term financing has very limited covenants than long-term sources of financing.
  • Limited formalities: Short-term financing has limited formalities than other sources of funds. Once it is fixed then can be easily renewed with short notice.
  • Flexibility: Short-term sources of financing are more flexible in terms of borrowing and repayment of funds as per the firm’s convenience.

Disadvantages of Short-Term Financing

Disadvantages of Short-Term Financing

Some of the demerits of Short Term Financing are as follows:  

  • The volatility of interest: Interest on long-term sources of financing is constant till the maturity period once it is fixed. In short-term financing interest on loans could be different at different loans.
  • Limited availability: Since short-term sources of financing are riskier, it is hard to obtain the funds for short period. Firms having low credit ratings may face the problem of obtaining an extension of funds as per their requirements.
  • Risk of non-extension: Sometimes short-term funds-providing institutions may refuse to extend the funds and that may lead the firm into bankruptcy.

Sources of Short-Term Financing

There are several short-term financing sources available to a firm. These sources and be broadly classified as secured and unsecured sources. Further, these two sources can be classified as spontaneous and non-spontaneous and account receivable financing, and inventory financing.

Sources of Short-Term Financing

A. Unsecured Sources 

Unsecured Sources of short-term financing are those that do not require any collateral. Firms with high credit ratings can use these sources. Unsecured sources can be classified as spontaneous and non-spontaneous sources. Lenders charge higher interest rates and processing fees for short-term financing due to the higher risk involved. When a company is limited in tangible assets or has a higher level of leverage, unsecured loans are often the only option.

In spite of the fact that unsecured loans do not have collateral backing, they still offer lenders and borrowers some value. Short-term loans that are unsecured retain some benefits for both parties. A borrower can obtain an unsecured loan from a bank, financial institution, or a private lender. Despite the lack of collateral and higher interest rates, the nature of these loans remains the same.

a) Spontaneous Sources: (i) Account payables,(ii) Accruals
b) Non-Spontaneous Sources: (i) bank loans,(ii) Money market Instruments

B. Secured Sources

Secured sources of short-term financing are those which can be obtained with collateral of assets. Unsecured sources of financing are based on the creditworthiness and financial soundness of the firm. There are many companies that have no good financial conditions and credit ratings and may be unable to obtain short–term financing funds can arrange funds with the help of secured sources. These sources of financing need a guarantee or collateral of assets. Here we discuss the short-term sources of funds with the help of inventory and accounts receivable.

a) Account receivable financing:  (i) Pledging AR, (ii) Factoring AR
b) Inventory Financing: (i) Floating lien, (ii) Chittal mortgage, (iii) Trust Receipt loan, (iv) field warehouse receipt loan, and (v) Terminal warehouse receipt loan.

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