How are the short-term financing needs of a small business met? Every business, regardless of size, has varying financial needs. It is important that all companies have a plan to finance those needs. One of the most important aspects of sound financial management is the careful monitoring and control of short-term financial needs. Short-term financing is any type of financing repaid within a year or less. It is used to finance day-to-day operations, such as payroll, inventory purchases, and overhead (utilities, rent, leases, and so forth).

As mentioned previously, cash flow budgets are prepared to assess whether a company has sufficient cash to fulfill regular operations. When the cash flow budget predicts gaps in cash needs, depending on the size of the business and the cash flow gap, several short-term strategies can be used to help meet the temporary gap. For Ginny, her immediate short-term needs are to pay for a new sewing machine and to find ongoing resources to pay her new employee.

What are some common sources of short-term working capital financing? When a company’s cash reserves will not cover its short-term expenses, small business owners often turn to the following sources of short-term financing:

• Self-financing/family/friends. The owners of small start-up businesses often fund cash flow gaps by tapping into their own funds or appealing to their friends and family for personal loans. Personal loans are not a recommended long-term or permanent strategy because they can lead to severed relationships if the loans are not paid back promptly. However, when financing agreements like these are used, both parties need to understand and agree to formal payment arrangements.

• Credit cards. Another approach many small businesses take to fund cash flow gaps is to use credit cards. Credit cards are a good way to defer payments, but they can become expensive if their balances are not paid off completely every month. A separate business credit card account should be established instead of using a personal credit account, if possible. Doing so protects the owner’s personal credit if he or she were to default on business payments. However, if the business is a sole proprietorship, owners can be held responsible for all payments, regardless of whether a business card or personal card is used. One of the few benefits of using credit is the potential for cash back and other rewards offered by several credit card companies. If the card is used wisely and balances are paid off regularly, these rewards can be a significant bonus.

Can suppliers help by providing credit? Businesses with good credit and an established relationship with their suppliers can take advantage of another credit relationship to help bridge the temporary gap: trade credit. Trade credit is the ability to purchase goods and services on credit from a supplier without paying interest. Suppliers will typically request payment within 30, 60, or 90 days and give a discount for early payments.

Trade credit terms are often expressed with three numbers, such as 2/10/60. The first number is the discount you would receive if you pay within the discount period, which is expressed as the second number. The third number is the number of days by which the balance must be paid in full. So, for a 2/10/60 trade credit, the business owner will receive a 2 percent discount if the balance is paid within 10 days. Otherwise the full balance is due in 60 days. Another way these terms are often expressed is 2/10, net 60.

Paying early to take advantage of a trade credit discount is wonderful if a firm’s cash flow is not a problem. If it is, deferring payment with trade credit is a good strategy because it does not tie up cash unnecessarily. Moreover, using trade credit keeps debt levels down, which is always attractive to outside investors and lenders. However, there may be disadvantages associated with using trade credit. If a firm does not pay on time, delinquency penalties are charged, and, if allowed to accrue, these penalties can be costly.2 Financial managers must weigh the costs and benefits of paying early for a discount or paying on time without a discount so that their cash is available longer. Figure 15.4 illustrates this decision.

Figure 15.4

Using trade credit can be advantageous but must always be evaluated and monitored carefully.

Can businesses turn accounts receivables into cash? Another strategy a firm can use to obtain cash quickly is factoring. Factoring is the process of selling accounts receivable for cash instead of using them as collateral for a loan. This takes monies owed to a company by its clients or supply chain partners and turns them to cash that a company can then use almost immediately. The factoring company pays the value of the company’s invoices, less a fee. Although it is generally costlier than obtaining a business loan, factoring is often easier to arrange, which is why companies often use it to bridge cash flow gaps.

How do commercial banks help with financial management? Commercial banks are financial institutions, credit unions, and savings-and-loan institutions that raise funds from businesses and individuals in the form of checking and savings accounts and then use those funds to make loans to businesses and individuals. Small start-up businesses rely on commercial banks for savings and checking services to pay bills and store excess funds. Checking and savings accounts are a form of demand deposit, funds that can be withdrawn (or demanded) at any time without prior notice.

As a business develops and is able to establish a good relationship with a bank, the business owners or financial manager may seek to open a line of credit. A business line of credit is credit that a manager can access at any time up to an amount agreed on between the bank and the company. The funds can be withdrawn all at once or in multiple withdrawals during the stated period. This is a common way of covering temporary cash flow shortages, purchasing seasonal inventory, or financing unforeseen operating expenses. Car manufacturers such as Ford and Honda often act as banks by providing their dealerships with lines of credit to purchase their inventories of vehicles.

Will banks lend money to small businesses? The credit crunch in 2009 and 2010 made it difficult for many businesses, small and large, to seek financing solutions from banks. Banks were not lending, and, if they were, the requirements were stringent. But according to the Thomson Reuters/PayNet Small Business Lending Index, which measures the volume of new commercial loans and leases to small businesses, lending to small businesses has been on the rise since its low in mid-2009.3 The economy is rebuilding, more businesses are seeking loans, and banks are beginning to respond. Many commercial banks offer loans to businesses for the purchase of equipment, property, or other capital assets. However, most banks require owners to provide business and financial plans, and personal and business financial statements, as assurance that the business is viable and worth financing. In many cases, banks require collateral, which is an additional form of security that assures a lender that the borrower has another way of repaying the loan. Loans that require collateral are secured loans. Sometimes the collateral is the asset that is being financed. For example, if a bank were to approve a loan to a company to purchase a building or new equipment, either one could serve as collateral. If the company were unable to pay down the loan, the bank would take possession of the asset as a substitute for the remaining loan payments. Other forms of collateral can include a business’s inventory, cash savings, or equipment. Some small business owners put up their personal assets as collateral, risking their homes, or retirement or other savings accounts. If the firm has an excellent credit history and a solid relationship with the lending institution, it may get an unsecured loan, which does not require collateral.

Are there other short-term loan options? Sometimes, a company is unable to secure a short-term loan from a commercial bank and has to consider other options besides traditional banking institutions. Nonbank lenders are financial institutions that extend credit or loans but do not hold deposits. These lenders will take on loans commercial banks view as too risky. Nonbank lenders are often more flexible in their loan terms. However, there is a price associated with this flexibility and availability: higher interest rates. Quality nonbank lenders are often difficult to locate, but Fundera (www.fundera.com), an online service, strives to help small business owners connect to appropriate nonbank lenders.

Microloans are small, short-term loans specific to small businesses. The Small Business Administration (SBA) created the microloan program in the early 1990s to increase the availability of funds to small business borrowers. Microloans are available through local nonprofit community-based intermediaries. The maximum loan amount for a microloan is $50,000, but the average microloan is about $13,000.4 According to the SBA, microloans may be used for ongoing business needs, such as working capital, purchase of inventory or supplies, purchase of furniture or fixtures, or machinery or equipment.

Are grants available to finance small business operations? Although most small business grants are targeted for specific research-and-development projects, grants can be found to help small businesses finance their ongoing operations. The federal government does not provide grants for starting or expanding for-profit businesses—only not-for-profit organizations. State and local governments are better sources for business grants, although often these grants are targeted toward specialized businesses that the state or local government is trying to develop, such as child care centers, businesses that improve tourism, or businesses developing energy-efficient products.

Is there a way to obtain loans without involving financial institutions? The accessibility and acceptance of social networks has given small business owners another interesting funding alternative: communities of individuals willing to lend or give money to help others succeed.

• Peer-to-peer lending is a growing source of financing for small businesses. As its name implies, peer-to-peer lending is the process of individuals lending to each other. Similar to eBay, where individuals sell their goods to other individuals, sites such as Prosper.com and LendingClub.com facilitate lending between individuals. This trend emerged as traditional bank loans became more difficult to obtain. Peer-to-peer loans generally have lower interest rates than commercial loans. Figure 15.5 illustrates the peer-to-peer lending process. For example, prospective borrowers with Prosper.com create an account that describes the purpose for and amount of the loan and a maximum interest rate they are willing to pay. In addition, borrowers must provide financial information from which the site creates a “credit grade” that helps prospective lenders evaluate the worthiness of a project and borrower. Loans may be funded by one or several lenders and are repaid directly through Prosper.com, which automatically debits the borrower’s bank account each month and then credits the accounts of the lenders.

  Figure 15.5

  How Peer-to-Peer Lending Works

  

  Figure 15.5 Full Alternative Text

• Crowdfunding is a way to generate funds via donations or, more recently, investments from individuals. Kickstarter (www.kickstarter.com) relies on donors. Donors receive products, perks, or other rewards from the companies they donate to on Kickstarter. Most successful donor projects raise less than $10,000, but there have been a number of projects that have raised funds in the six- and even seven-figure range. Pebble Watch, a maker of smart watches, sought to raise $100,000, but ultimately raised more than $10 million from 85,000 backers.5 Crowdfunder (www.crowdfunder.com) offers both donation-based and investment crowdfunding opportunities and has attracted a growing community of investors, tech start-ups, and small businesses. Investors gain ownership or a promise of future returns. AngelList (www.angellist.com) is another investment crowdfunding site.