When is short-term lending expensive?

Almost every SME-owner who is looking at different funding options for their business complains about the difficulty of understanding and assessing the costs of funding options - especially when it comes to working capital.

We have been taught by banks that we should be looking for an 'annual percentage rate' (APR) to assess the cost of a loan. 

This number made for a good 'apples for apples' comparison when small businesses were primarily looking for long-term bank loans structured with monthly repayments over a number of years or traditional overdrafts.

Focus has shifted to shorter term lending

In today's world, many businesses are looking for much shorter term lending - often as short as two months or even a few days. 

Like Sarah who runs a successful hotel that arranges wedding packages and has to pay the florist, musicians and wedding cake maker two months before she receives full payment from her customers. 

Or Anna who uses Asian suppliers for manufacturing high-end handbags and needs to bridge a two week gap between a supplier payment that's due and an expected customer payment.

Making it easy to compare the total cost of funding

No one would intuitively look at an annual rate of interest for such a short-term loan. The more sensible way of looking at such a short-time period is to assess the total cost of funding - comparing what is lent in pounds and pence with what the customer is expected to repay. It really is that simple.

Think of giving a customer a discount for early payment - say offering a 2% discount for immediate payment rather than in 30 days. Many businesses have this type of arrangement and offer discounts for early payment on a regular basis. However, if you compared this to the cost of a bank loan, this discount would translate into an APR of ~25%.

But it is important to remember that the business is not actually paying 25% interest. Instead the business is forgoing 2% of the value of the invoice for a very convenient way of getting customers to pay faster and reducing the amount of working capital the business needs.

This thinking may also be is a sensible way to benchmark what a business may be willing and able to pay for a short-term loan. What discount are you giving your suppliers? Let us know.