In the business world, debt is inevitable. At some point in your business lifecycle you will be forced to walk into your commercial bank to borrow some money to run operations in your small business. Different businesses will borrow due to different reasons which include; funding expanding product lines and services and meeting short-term cash shortages within the business among many other reasons. When planning to approach a financial institution to get a loan for your small business, you need to first determine whether you actually need the loan or not. In addition, after determining that the loan is a necessity for your business, you need determine which type of loan to take in order to meet your financial obligations.
As a business you have an option of going for short-term or long term loans depending on what the borrowed money will be used to finance. Generally, for long-term projects such as purchase of new equipment and machines, opening of a new branch or launching of a new product line; you will likely go for a long-term loan. Long term debt will be the most suitable in this case due to the fact that you will most likely be borrowing huge amounts of money that will require a long repayment period considering the cash flow levels at your small business. In addition, the interest rate on long term debt is always lower than the interest rate on short term debt; hence you will have both prolonged your repayment period in order to pay smaller installments, and reduced your debt burden at the same time.
On the other hand, short term business loans are not suitable for all businesses. For instance, if you are a real estate company that is engaged in long term development projects which will take more than one year to start generating cash flows; short term debt is not appropriate for you. This is due to the fact that you will end up defaulting on the short term debt which usually has a credit period of less than one year. After defaulting on your short term loan you will risk being blacklisted by the credit bureaus within your jurisdiction and beyond. With very few companies willing to give a loan for bad credit, you will ultimately find yourself with limited access to credit finance and your business growth will be adversely affected in the long run.
Short term loans are however not a bad idea for small businesses which are growing fast; with an accelerating need for higher liquidity to keep daily operations running. But before you get the short term loan, you must ensure it is for the right reason; and the reason must be short term too. Situations when short term borrowing for your business is ideal include the following:
1. Covering your cash flow cycle gaps
If you are selling your goods or services on credit, you will in most cases be receiving cash from your sales after 15, 30, or 60 days depending on the agreed upon receivable days with your buyers. In the meantime as you wait for your cash to be deposited into your bank account by your buyers, there will be other operations running at your business that will require immediate funding. These include activities such as purchase of raw materials, office running costs and payment salaries and wages. To meet these short term financial obligations you can opt to get a short-term loan as you wait for your clients to pay when their credit period is over.
2. Meeting seasonal demands
If you are operating a business that is seasonal, you will always find yourself having higher expenses during peak seasons and lower expenses during the off-peak seasons. This is due to the fact that during the peak season you might need to hire more part-time employees and increase your stocks to meet the growing demand; especially during holidays. In some cases, the demand might end up overwhelming you even after planning for the anticipated upsurge in costs. To bridge this kind of short-term financial gap you can opt for a short term loan too.
3. Funding emergencies
Even with insurance coverage for your business, there are some business emergencies that need immediate fixing and they cannot wait for the bureaucratic insurance claiming process. For instance if your computers crash, you will need to replace them immediately in order to continue with your business operations. Chances are that you might not always have enough budgets for such one-off emergencies; and so taking a bank overdraft from your banker will help fix the problem much faster.
Both short-term and long-term borrowing can be ideal in different situations for your small business. The rule of thumb to always remember is that you should always match short term debt with short term financial needs; while long term financial needs should only be funded using long term debt.