Working capital loan vs. term loan: Which is the better option?

Multiple businesses may borrow money for multiple reasons, including keeping their operations sustainable, keeping management running, long-term company growth, etc. Working capital and term loans fulfil these needs for companies. Both serve different features and functions for businesses under the umbrella of a similar purpose, which is funding. In this blog, we will learn about the core difference between working capital and term loans and which can be the better option. 

Key takeaways: 

1. Working capital is a short-term fund that is responsible for covering the daily running costs of the business. 
2. A term loan is the amount a financial institution or an NBFC offers you, which you will repay over an agreed tenure. 
3. There is a broader difference between working capital and a term loan when it comes to functionality. 

What is working capital? 

Working capital is the short-term finance provided to companies or businesses for their daily costs. It shares the responsibility of keeping the company sustainable and keeping daily management efficient. 

Here are the uses of working capital: 

1. Efficient inventory purchase.
2. Manage employee salaries. 
3. To cover the rent. 
4. To fulfil the gaps while waiting for customers’ payment.

Hence, these are some of the reasons why working capital is needed to keep the essence of the business or company alive and sustained. One needs to keep in mind that such short-term loans may depend on the lender’s policies, because these types of loans may be revolving, like overdrafts, cash credit facilities, or straight short-term loans with fixed instalments. 

What are the pros and cons of working capital? 

There are multiple advantages and disadvantages of working capital that working capital one needs to keep in mind while understanding this concept in detail. 

Here are the pros and cons of working capital: 

• Pros of Working Capital

Working capital offers several benefits to a business. Some of the main advantages are:

1. Helps run the business smoothly

Working capital helps a business manage its daily expenses without interruptions. Without having enough working capital, it can be difficult for a business or company to function in its daily responsibilities. 

2. Helps maintain the company's goodwill

Having enough working capital can help a company maintain its goodwill among suppliers, creditors, and employees. If a company struggles to manage its working capital, these parties may lose confidence in the business. This can make it harder for the company to maintain its operations and obtain support from others.

3. Provides better bargaining power

Working capital may provide flexibility to the company or businesses when dealing with suppliers. For example, if a business pays in advance for raw materials, a supplier may facilitate a discount. This can help the company reduce its purchasing costs.

• Cons of Working Capital

Although working capital is important, having too much of it can also create certain problems.

1. No return on surplus capital

Surplus working capital does not usually generate interest for the business. When too much money is kept as working capital, the company may miss opportunities to use that money for other productive purposes. Therefore, a business needs to maintain the right level of working capital.

2. Risk of unnecessary spending

Having excess working capital may encourage a company to spend money on items that are not necessary for its operations. Such spending can lead to the wastage of funds and may affect the company's financial position.

3. May be used for long-term needs

Working capital is mainly meant to meet short-term business requirements. However, some companies may use it to finance long-term projects. This can create problems because short-term funds may not be suitable for long-term expenses and could affect the company's ability to meet its immediate financial needs.

Hence, these are the pros and cons of working capital. 

What is a term loan? 

A term loan is a loan provided by banks or NBFCs for an agreed period of time, which can be short-, medium-, or long-term. 

Here are the uses of a term loan in business: 

1. Buying machinery.
2. Business or company expansion. 
3. Buying commercial properties. 
4. Enhancing corporate facilities. 

Hence, these are the uses of the term loan. A term loan cannot usually be drawn again once it has been repaid.

What are the pros and cons of the term loan? 

When understanding the concept of a term loan, it is important to properly determine its advantages and disadvantages. 

Here are the pros and cons of term loans: 

• Pros of term loans: 

• Needs: A term loan can be used when there is a need for funds to buy new inventory, expand the business, purchase commercial properties, etc.  
• Repayment is fixed and agreed: The loan comes with a fixed and agreed repayment cycle, so the borrower can plan the repayments along with other business expenses.
• Can support a credit record: Regular and timely repayments may help the borrower maintain a good credit history.

• Cons of Term Loans

1. Longer tenure may increase total interest: Choosing a longer repayment period may lower the monthly instalment, but it can also result in a higher total interest cost over the loan tenure.

Hence, these are the pros and cons of the term loan.