SMEs have multiple sources of raising capital. Term loans and working capital loans being two of the many options. Depending on the nature of the business and the reason for the loan, the business owner can decide which of the loans the correct choice is. Let’s take a closer look at the difference between the two and how an SME entrepreneur can make this choice.
What is a Term Loan & How Does it Work?
Typically, a term loan is the more popular and mature choice in the Indian business market. A loan from a loaning agency or a bank wherein the amount, tenure, and interest rates are defined at the start is a term loan. There will be a fixed interest rate or a floating interest rate.
Often, a term loan requires a fairly large down payment and have considerably small EMI amounts. Hence, it is always advised to businesses that are established and have a healthy financial statement. Term loans are mainly taken for specific investments like fixed assets, acquisitions, equipment, real estate, and plant & machinery.
Today, with efficiency and the latest technology, term loans are disbursed quickly by financial institutions and loan agencies. These corporate borrowings are paid off in anywhere between one and twenty-five years. In this age where the SME sector is booming, it’s no surprise that many banks, financial institutions, and loan agencies have new and improved programs specifically crafted to cater to small and medium businesses.
There are short-term loans and long-term loans available with fixed or floating interest rates that depend on the guidelines set by the lending company. Agencies usually offer three types of term loans that are differentiated based on their lifespan or repayment tenure.
Short-term loans are taken by small businesses who aren’t established and thus, don’t have very high credibility. These loans can be repaid between twelve and twenty-four months. Intermediate loans are taken by those companies who are a little more settled in their business and can pay monthly instalments from the cash flow of the company. The tenure set for these loans by loan agencies is between one year and three years.
Finally, there are long term loans that can go up to twenty-five years. Companies take a long-term loan after having carefully thought about it since they will have to restrict other financial commitments as well as ensure profit so that there are no defaults in the loan repayment, for a very long period.
What is a Working Capital Loan, and How Does it Work?
A loan that is taken to meet everyday business operations is a working capital loan. While term loans are taken to invest in long term assets, working capital loans are for smaller operational needs of the company, like salaries, rent, and if the company has incurred any debt.
Sometimes, business owners have small bottlenecks like a sudden expense which will lead to an imbalance in the cash flow. When there are inadequate cash and no asset liquidity, it is wise to secure a working capital loan. Companies that have seasonal sales because of the nature of their product or service rely on these working capital loans to run everyday business activities.
For example, manufacturing companies that have a niche target audience will need working capital loans because their target market is limited, and they will have high sales, but which is seasonal. Like this, there may be many other companies across industries that, because of the nature of the business they are in, are unable to spare funds from the monthly earnings of the company. Hence, business owners are recommended to secure a working capital loan.
Apart from the nature of the business, there are other reasons as well as to why a company will opt for a working capital loan. Sometimes, due to unfortunate circumstances, the business will not run as planned. This may be due to poor estimations, sudden changes in the market, the birth of a new strong competitor, or changes in the company internally.
This will lead to the owner needing all the current business funds to invest smartly in a revised business plan. Hence, a loan will be required to ensure that the day to day activities are not affected and continue to run smoothly.
There are various pros and cons of taking a working capital loan. Of course, the obvious immediate benefit is that it is easily obtained and will quickly help the company to fix any operational gap that exists. Working capital expenditures will be covered efficiently. Thus, keeping the company away from any unnecessary embarrassment. It is purely debt financing and not any kind of equity transaction.
The business owner is in full control of the company. If the credit rating of the business owner is very high, there is no need for any collateral to secure the loan. These kinds of unsecured loans prove to be beneficial to the business owner. Companies whose owners have very little or no credit in the market will have to secure the loan against collateral. When a working capital loan needs asset collateral, the loan process can be an inconvenience to the entrepreneur.
A few other cons of securing a working capital loan can be that the loan is almost always on the business owner’s name which means that any default and missed payments will directly affect his/her credit score. The lending institutions like the loan agencies and banks incur a higher risk when it comes to working capital loans since there is no collateral and the payments will be made only when the company makes profit. For this, the business owner must have a sound business plan and correct forecasts of the market and estimated profit.
The SME business owner can, in this way, decide which loan is more suited for business operations. It mainly depends on the primary reason for securing the loan. The correct type of loan will ensure smooth functioning of the business and will, in turn, lead to the growth and development of the company.