Working Capital Loan vs Term Loan – Which Should You Opt For?

The need for financial support will come up repeatedly when you are running a business. Term loans and working capital loans are two credit instruments that business owners may need to choose between to get the required funds. There are a few pertinent differences between them. If you are clear about your financial requirements and business goals, it will be easier to decide which one you should seek at that point in time.

Working Capital Loan

A working capital loan is one that is taken to finance a business’ day-to-day operations. These loans are not for buying long-term assets or investments; they cover a company’s short-term operational needs. These can include costs like payroll, rent and debt payments. Thus, working capital loans are simply corporate debt borrowings in order to finance routine operations.

Manufacturing sector businesses, for example, have cyclical sales corresponding with the needs of retailers. Maximum sales take place during the fourth quarter – the holiday season – and, therefore, manufacturers customarily carry out production during the summer months, building up inventories for the fourth-quarter push.

When the end of the year comes around, manufacturing requirements reduce as retailers are intent on selling their entire inventory. This curtails manufacturing sales and, therefore, the fourth quarter is a quiet period for the manufacturing sector.

During this time, manufacturers often require working capital loans to pay wages and other operating expenses. These are liquid loans with a short term, given for a year or less. The loan is typically repaid by the time the company re-enters its busy season.

Term Loan

A term loan is a loan for a specified amount, with a set repayment schedule and a fixed or floating interest rate. It is appropriate for an established small business that has sound financial statements. A term loan may also require a sizeable down-payment, which reduces the repayment amounts and the total cost of the loan.

For corporates, a term loan is typically for machinery, realty, or working capital paid off between one and 25 years. Often, a small business may use the funds to purchase fixed assets for its production process; others might borrow the cash month-to-month to pay operational expenses. Banks often have their own term loan schemes to help companies.

A term loan carries either a fixed or a variable interest rate – based on a benchmark rate like the U.S. prime rate – a periodic repayment schedule, and a maturity date. If the loan funds are used to purchase an asset, then the useful life of the said asset can also have an impact on the repayment schedule. The loan requires collateral as well as a rigorous approval process to reduce the risk of default.

Term loans can be either long-term, with fixed payments, or short- or intermediate-term. Short-term loans are generally offered to companies that don’t qualify for a line of credit and usually extend for a year, though they can also run for up to 18 months. Intermediate-term loans generally run for between one and three years, paid in monthly installments from a business’ cash flow. Short- and intermediate-term loans may require balloon payments, in which the final instalment “balloons” into a much larger amount than any of the preceding ones.

Which One Do You Need?

If you have operational expenses that need to be met in the short term – during a lean period in your cycle of operations, for instance – and only need a small amount, then a working capital loan is what you should seek. They are easy to obtain, especially with a good credit score, and there is a lesser amount of paperwork involved. However, the interest rates are on the higher side in order to deter defaults.

On the other hand, if you aim to expand your business by investing in new machinery or other fixed assets, you should opt for a term loan. Working capital loan proceeds cannot be invested, so you will need a term loan if your goal is business growth. While initial interest rates are lower, the final amount you repay will be higher due to the increase in interest rates over the loan period. Term loans are not as easily obtained as working capital loans, as banks assess several factors to determine whether or not to grant the loan: creditworthiness, bank statements, collateral, repayment ability and the market reputation of your business.

Both types of credit will be required at different points in time when you run a business. By identifying your business goals and carefully tailoring your financial needs to suit those goals, you will be able to obtain the desired credit at the right time.

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