The Disadvantages of Short-Term Debt

There are times when a business needs cash in a hurry. For example, if the business is having trouble paying its employees for the next couple of months but expects a substantial increase in clash flow a few months down the line, the business may look for a short-term loan in order to tide them over. Short-term debt is generally due within a year's time. Short-term loans can be beneficial to get you through a tough time, but there could be drawbacks.

Investors you may be wooing will look at your financial statements before they make a substantial contribution. They want to see that you have available cash flow and the credit rating to get yourself out of a jam if you needed more money in a hurry. The presence of a short-term loan can inflate your numbers and make it appear that your business is in financial trouble. Open loans reduce your ability to get approved for long-term loans and increase your current overhead. Investors see your business as a risky investment that could falter under the pressure of a short-term loan. Jennifer Lindsey, author of "The Entrepreneur's Guide to Capital," says that lenders ideally like to see a two-year operating history, a stable management group, a desirable niche in the industry, a growth in market share, a strong cash flow and an ability to obtain short-term financing from other sources as a supplement to the loan.

Any late payment on the short-term debt can negatively impact your credit rating. Your new debt to income ratio, inflated by the new loan, will also have a negative impact on your credit rating. Dunn and Bradstreet is one of the companies that provides commercial credit risk information similar to the concept behind the FICO score for individuals. Once you've paid off the loan, your rating with D&B will improve, but during the period that your debt seems to outweigh your income, your risk assessment will be less than positive. DP Information Group (DP Info), Singapore's leading credit and business information bureau says, "Short-term debt financing has to be monitored closely to avoid bad relationships with suppliers and bankers or a bad reputation in the industry for not paying debts on time."

Short-term debts are best if your business has an immediate need for more cash. Immediate needs for a short-term business loan could be to meet payroll while awaiting a large cash lump sum or to buy materials to produce your hottest selling product after you have sold out. They are not good for financing entire new business ventures in which it could take years before the business starts to turn a profit or to build a new facility with a substantial mortgage because the money due on these loans is due within a year.

Lenders to small business owners often have severe penalties for late payments. They can increase your interest rate on the loan, add late fee charges to the loan or request that you pay the loan off early. For most small businesses, making this additional monthly payment is already a burden. Any increases in the payment could cause you to default, labeling you as a credit risk. Trying to make the payments on these loans could hinder your performance on other loans or responsibilities that you have, thus putting you further into debt instead of helping you improve your business. Falling further into debt puts unwanted strain on the day-to-day operations of the business. Decisions from management team focus on meeting the immediate loan needs instead of looking into the future.