Understanding Working Capital – Term Loan Differences

You may be wondering the difference between term loan and working capital loan. Read ahead to know the difference!

This is a question that many businesses will face in their lifetime, sometimes even more than just once. The need for financial support may come up a lot when you’re in the business world, so you need to set your financial sources straight and know what’s your best option for getting the funds you need. And, these term loans and working capital loans are the main factors that you need to think about when making your decision. There are a couple of differences between them, so here is all the important information you need before making the final decision.

Working Capital Loans

A working capital loan by design is a type of loan meant to repay a business’s short term operational cost. The loans are usually spent on working capital (day-to-day) operational costs – either in purchasing stocks, paying salaries, or managing effects of seasonal change in cash flow (high or low). Working capital loan amounts are relatively smaller and can be sanctioned quickly, meaning the business does not need a long process before approval. Working capital is a really important funding source for businesses. The working capital for them is the immediate cash they receive for the daily expenditures that the business encounters. Usually, the need for working capital shows up when businesses have to pay the monthly rent, or pay the salaries to the employees or cover some seasonal demands that have shown up in the last minute. The assistance they get from these types of external funding sources helps them to get back on track and continue with their work. A type of assistance that you can get for working capital is a working capital loan.

You need to know that you cannot use the working capital loan for new investment, to start a new project or expand the business that you already have. These are liquid loans with a short term. The period for which these loans are given is usually a year or less.

The positive side is that they are really easy to get, especially in situations where your credit score is at a good level. The paperwork is not huge since it’s a short-term loan. But, the interest rates are high.

You can use a loan calculator to estimate the requirements for working capital. The calculator will help you to analyse the inventory that has been built up, to add all of the cash that you already owe and also take in consideration the amount that you are supposed to pay to the suppliers. This helps in easier repayment of the loan that is taken.

Working capital loans, in comparison with terms loans, are relatively easier to get, especially with a good credit score. A working capital improvement is the main goal of such loans.

Features of Working capital loans are as follows:

• Working capital loans are advanced for short durations, typically between a few months and one year.
• Quick access to funds: This often gets approved much faster than conventional loans, and hence it is a source for quick access in case of any business emergency.
• Higher Interest Rates: as these loans are short-term and the collateral is lesser, their interest rates might be more in comparison to conventional loans.

Term Loans

For newer entrepreneurs a question may arise – what are these loans? What are its features? Read along to know the details.

Term loan meaning is often confused with business loans with fixed tenor, higher interests, and ones that are collateral free. However, term loan refers to a financial product that has a higher amount for capital and is put into longer periods of investments. Businesses apply for term loans to pay-off bigger expenses like equipment purchase, investment into real estate, expansion activities, special projects, etc. Term loans, as the name suggests, are loans that take more time, from one to ten years. These term loans are taken when you need funds for larger investments, for expansion of your business or for purchasing new machinery or tools. These loans usually involve higher sums of money than the working capital loan, and this is the reason why they are paid off during a longer period.

We mentioned that the interest rates for working capital loans are high, and this can lead people to think that it’s an expensive loan. But, with the term loans, the interest rates keep growing with the years, so in the end, you pay more in interest for the term loans when compared to working capital loans.

You have a business loan calculator which can help you in estimating the total of the repayment, along with the interest and the principal.

Because this is a long-term loan, it requires a lot of paperwork and many procedures. So, it’s not that easy to get it. Financial institutions need to check everything before approving or denying the loan request.

Features of business loans are as follows:

• Long repayment period : Business loans are usually issued for longer periods of time, ranging from a year to several years or maybe even decades. This allows the businesses to repay the debt in longer time frames with greater flexibility
• Lower interest rates : The lenders have competitive interest rates on offer. In some cases, these loans are backed by some form of collateral which makes it a safer investment for the lender.
• Fixed payment structure : These loans have a fixed payment structure, with the repayment schedule spanning over multiple years, the payments at regular intervals have both principal and interest component in it. At the end of the repayment schedule, the loan is repaid in full, including both interest as well as the principal component
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What’s checked?

• Bank statements : Lenders check bank statements to gauge the cash flow, and to determine the repayment capacity of the business. Bank statements helps assess the liquidity position of a business
• Market reputation : Market reputation is a great indicator of the business’s operational efficiency. It indicates what the market participants think about the business, if the business has any bad debt, outstanding vendor payments for a long time, etc. It gives an indication to the lender on the possible risk associated with releasing the loan.
• Ability to repay :
• This is the most crucial aspect of background checks performed by the lender, it allows the lenders to understand the ability of a business to repay the loans. They make this assessment based on financial health of the firm, efficiency at which the firm operates, goodwill in the industry, and some other parameters to come to a conclusion if the risk to reward ratio in releasing the loan is worth it. Lenders also do a credit history check to look for past debt records and their repayments.
• Creditworthiness :This is gauged on the basis of past credit records, lenders check past records to check if the borrower has defaulted in the past or has faced any financial difficulties in repayment of previous loans. Businesses with more creditworthiness may be able to secure loans at attractive terms and interest rates. 
• Collateral : Some lenders may ask for a guarantee to make sure that the loan to be repaid by auctioning off the collateral in case of default. Collateral can be in the form of any asset like gold, plants and machinery, factories, lands, property etc. As long as the collateral’s market value covers the principal amount of the loan.

The success of your business depends a lot on the funds that you use and how you tailor those funds to suit your environment. Deciding on which type of funding to get will mostly depend on what exactly your requirements will be.

Summary:

A working capital loan is used mainly for short term operational expenses or day-to-day running costs of a business. Like salary payments, rent payments, purchase of inventory for trade, etc.  Such loans are usually small, have a shorter period of repayment terms (usually within one year) and are usually sanctioned; hence these loans can be availed in urgent need.However, the rate of interest is usually on the higher side as the because of their nature and fewer collateral required. 

Term loans are targeted towards large scale and long term investments like equipment purchase, expansion in new markets or products, or to fund a special project. These loans have a high tenor, ranging from 1 year to a couple of years or maybe even decades. Despite requiring more documentation and having a more extended processing period, they often have cheaper interest rates along with a structured repayment structure that helps organizations better plan their long-term budgeting as well.The parameters of eligibility for term loans will comprise the assessment of the financial soundness and creditworthiness of the borrower and also the possibility of repaying the loan. Such loans can also have collateral demands.

Working capital loans are generally best for immediately raising short-term capital in a business firm, while term loans will be ideal for substantial, long-term investment projects. Understanding the differences between these types of loans will help manage resources and their deployment optimally in plans for growth.

FAQs:

1. What is a working capital loan?

Working capital loan is a loan that helps a company to fund the everyday operations. This capital covers short-term financial needs.

2. What is an example of a term loan?

A bank loan with varying interest rates, taken for starting new ventures, new projects or business expansion is a term loan. This loan needs to be paid in a certain amount of time.

3. How many business days after you submit your application will you receive a loan estimate form?

Usually, it takes up to 3 business days.

4. Can Term Loan be given for Working Capital?

While a term loan and a working capital loan serve distinct purposes, a term loan isn’t typically designated for working capital needs. Term loans are long-term financial products for major investments, while working capital loans address short-term operational expenses. The key difference lies in their respective usage: term loans for strategic projects and working capital loans for day-to-day operations and liquidity.