Key Difference – Term Loan vs Working Capital Loan
The key difference between term loan and working capital loan is that term loan is a form of borrowing where the payments can be made over a predetermined period of time in regular intervals whereas working capital loan is a loan taken out to finance routine business operations to minimize shortfalls in working capital. While the intention of both is to obtain funds for business use, the circumstances under which they are applied varies notably. Thus, it is vital to distinguish between them clearly.
CONTENTS
1. Overview and Key Difference
2. What is Term Loan
3. What is Working Capital Loan
4. Side by Side Comparison – Term Loan vs Working Capital Loan
5. Summary
What is a Term Loan?
A term loan is a loan that is repaid in regular intervals over a pre-agreed period of time. The time period of a term loan can last between one to ten years; however certain term loans may last as long as 30 years. Term loans are divided into two main categories.
Fixed Rate Term Loan
A fixed interest rate loan is a loan where the interest rate does not vary during the term of the loan.
Floating Rate Term Loan
In a floating interest rate loan, interest rate fluctuates during the term of the loan.
Term loans are a popular financing strategy predominantly utilized by small businesses, where they usually apply for long term loans. This is because the monthly installments will be smaller, which is convenient to be paid even if the business is not making significant profits. On the other hand, businesses should also be mindful of overly lengthy terms in case of floating rate loans due to the possibility that interest rates may fluctuate significantly.
Figure 1: Long-term floating interest rates are subjected to significant fluctuations
What is Working Capital Loan?
A working capital loan is a short term loan with the aim of financing the day to day business operations of a company. Working capital loans are not used to inject capital into the business or to purchase long-term assets or investments. Instead, it is used for aspects such as to settle accounts payables, pay monthly interest or with regard to any aspect that is involved with current assets and current liabilities.
Ideally, a company should always have sufficient cash to operate routine business operations. This can be achieved through effective working capital management. However, in practice, certain companies may struggle with the cash situation. This is predominantly based on the industry where the sales are seasonal in nature. Another situation that companies will require increased working capital is if it is pursuing an aggressive growth strategy. In such cases, the sales are growing at a rate that cannot be financed effectively; which is referred to as ‘overtrading’.
The requirement for a working capital loan depends on the nature of the prevailing working capital position. It can be calculated as per below.
Working Capital Requirement = Inventory+ Accounts Receivables – Accounts payable
The most common method of obtaining a working capital loan is through a bank overdraft. This is a facility granted by banks for its creditworthy customers, allowing them to withdraw funds up to a limit that exceeds their bank balance.
What is the difference between Term Loan and Working Capital Loan?
Term Loan vs Working Capital Loan |
|
| Term loan is a form of borrowing where the payments can be made over a predetermined period of time in regular intervals. | Working capital loan is a loan taken out to finance routine business operations to minimize shortfalls in working capital. |
| Time Range | |
| Term loans may be short, medium or long term. | Working capital loans are short term loans. |
| Installments | |
| Repayment of a term loan is done by many installments. | Repayment of a working capital loan is done by a limited number of installments. |
Summary- Term Loan vs Working Capital Loan
Term loan and working capital loan are two popular types of loans, especially among small businesses. The difference between term loan and working capital loan mainly relates to the purpose and the time period they are taken for. Term loans usually serve the purpose of gradual business growth and may be short, medium or long term. Working capital loans are applied for if cash deficits are experienced as it is difficult to carry out day to day business operations without sufficient cash.
References:
1.”Working Capital Loan.” Investopedia. N.p., 30 Sept. 2004. Web. 23 Mar. 2017.
2.”How to Calculate Working Capital Requirement.” Plan Projections. N.p., 23 Mar. 2017. Web. 28 Mar. 2017.
3.”Term Loan.” Investopedia. N.p., 15 Feb. 2017. Web. 28 Mar. 2017.
4.”What is overtrading.” Nibusinessinfo.co.uk. N.p., 24 Feb. 2017. Web. 28 Mar. 2017.
Image Courtesy:
1. “Inflation-Indexed Government Bond Yield” By Ben Bernanke – (Public Domain) via Commons Wikimedia