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Short-Term Financing

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Differentiate between types of short-term financing.

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[MUSIC PLAYING] This is Dr. Bob Nolley. And in this unit, we wrap up our discussion of working capital management by looking at short-term loans.

Short-term loans are borrowed funds that are used to meet obligations for just a few days or up to a year. Anything longer is not short-term. With a short-term loan, you receive cash from your lender more quickly, but it also needs to be repaid in a shorter timeframe.

Probably the most common way for startups to get funding is the asking of families and friends. A young and energetic entrepreneur has a great idea for a startup, but doesn't have the money in his personal savings. Friends and family may be older and have some money set aside. Parents or other family members should definitely not risk all of their retirement savings on your startup. But they may be willing to risk a small amount to help you out.

Friends in age similar to you might be willing to work for little or no wages until your cash flow turns positive. And this is where the term sweat equity is often used. The owner rewards this type of loyalty with a small percentage of ownership of the organization in lieu of cash.

A variation of this is barter or trade. And in this method, you provide a needed service, such as consulting or management advisor, in return for the resources needed for your startup at the time.

After friends and family, there has been an increase in person-to-person lending. Person-to-person lending, also called Peer-to-Peer lending, or P2P lending, occurs directly between individuals or peers without the intermediation of a traditional financial institution.

For the most part, it is a for-profit activity which distinguishes it from charities or philanthropy or crowdfunding. Peer-to-peer lending saw a huge growth during the economic crisis of 2007 through 2010.

Peer lenders were willing to provide credit at a time where banks were not willing to lend. In P2P lending, lenders could charge below market rates to help bar and lessen the risk.

One advantage to the borrower is that rates may be better than traditional bank rates could offer. The advantage to a lender is they get a higher return than they were just having money sit in the low-yield savings account.

Commercial banks offer loans to businesses. And they could be secured or unsecured. A secured loan is when a borrower pledges some property as collateral for security to the credit being extended and to have the money lended to them. If the borrower defaults, the creditor gets possession of the assets.

Commercial banks can also offer unsecured loans. These include credit cards or lines of credit. And they typically incur a higher interest rate because they are a higher risk to the lender.

When the business is a going concern, probably the most common type of short-term financing is the use of trade credit. Trade credit is a variable source of alternative funds for personal and business loans. This is the money owed by a business to its suppliers when inventory is received and recorded on the balance sheet as accounts payable until it's paid.

Most often, a supplier will send an order to a business, issue a bill, and collect the payment later. This is the important part of the cash conversion cycle because the business has the inventory but they haven't paid cash for it yet.

Sometimes, the supplier will offer a discount if the bill is paid early. These terms are an example, such as 2/10 net 30. This means that a business can take a 2% discount if it pays within 10 days, otherwise the balance due must be paid in 30 days.

And while this discount may seem attractive, the business must weigh that against shortening its cash conversion cycle by 20 days in this case. It is also important not to abuse any trade credit extended. The business could run the risk of not having the credit available due to being a slow payer.

A less widely used method of short-term financing is factoring. Here, a business sells its accounts receivable to a third party, called a factor, at a discount price. This allows the business to a substantial part of its accounts receivable to cash. And therefore it can pay its suppliers or other debtors more quickly.

The transaction can be negotiated with or without recourse. With recourse, the risk for any bad debt remains with the business. But without recourse, the risk goes to the factor.

Now let's review the key points on short-term financing. The most common way for entrepreneurs to start a business is through family and friends. After that, peer-to-peer, or P2P, lending is available, often at a lower rate than that available from financial institutions.

Commercial banks also offer secured and unsecured loans, secured loans requiring collateral but also offering a lower interest rate. Unsecured loans include credit cards and lines of credit.

For the going concern, trade credit is often used. A business taking advantage of this does so by having its vendor ship inventory to it, and then pay the bill when it's received. This has a positive impact on the cash conversion cycle.

A company could also consider factoring, involving the sale of their accounts receivable at amount below its stated value.

This is Dr. Bob Nolley.


Terms to Know

A financial transaction whereby a business sells its accounts receivable to a third party (called a factor) at a discount.

Peer-to-Peer Lending

A type of financing which occurs directly between individuals or “peers” without the intermediation of a traditional financial institution.

Trade Credit

A loan extended by suppliers who allow businesses to buy now and pay later.