What is the difference between a business line of credit and a working capital term loan?

Introduction

Mr Alok Srivastava, a dealer in auto-parts in Gurugram is a worried man nowadays. The recent slowdown in business activity has left him in a tight spot on how to cover the expenses with the current decline in sales. However, this situation is not unique to Mr Srivastava and there are some easy solutions to help your business tide over a difficult time.  

Every business, whether big or small has its peaks and troughs, but the monthly expenses do not stop coming. In addition to that, there are unexpected expenses such as machinery breaking down or damage due to fire or in the case of natural calamities etc.

To overcome all such situations, businesses require funds to ensure smooth functioning. In case of a shortfall, small business loans are the most suitable form of financing to meet all your short term financial obligations.

A small business loan ensures business continuity by maintaining a positive working capital and prevents you from missing out on opportunities that come your way.

When you do decide to take a small business loan, you must also understand which loan product suits your needs. Is a business line of credit your best bet or is it advisable to take a working capital loan to meet your requirements? To help you make this decision, here is an explainer on a business line of credit and a working capital term loan.

What is a Business Line of Credit?

A business line of credit, also known as a cash credit loan, lets you borrow funds based on your business inventory level and account receivables. This is a revolving credit facility, which means that the credit limit gets renewed automatically after the loan is repaid in full. 

However, businesses availing this facility need to send inventory and receivables report to the lender every month. Based on the limit extended by the lender, a business can withdraw the required money and only pay interest on the amount borrowed.

The loan has to be repaid within a period of 90 to 180 days. A business line of credit is usually unsecured in nature, which is why businesses require a good credit score to qualify for this loan type. Another requirement businesses must meet to avail a line of credit is good cash flow management. 

This loan type is mostly used to finance short-term working capital requirements like purchasing inventory, meeting urgent repair expenses or meeting cash flow shortages.

What is a Working Capital Term Loan?

A working capital loan is different from other term loans, which are generally taken to fund businesses' capital expenditure plans. Additionally, it has a longer repayment tenure and a relatively low interest rate. 

A working capital loan comes with a pre-determined credit limit with a fixed interest rate and payback tenure. It is used to fund the day-to-day operations of the business like purchasing inventory, payment of salary, electricity bill, paying vendors etc. 

These are unsecured business loans and are approved based on the business's financial status, inventory turnover ratio, receivables turnover ratio etc. The loan tenure varies between 12 months to 60 months and the interest rate ranges from 11% to 20%, depending on the credit profile.

Compared to the business line of credit, working capital loans are easier to obtain and tend to get processed faster. A working capital loan helps businesses manage sales fluctuation, normalise cash flow situation and leverage new business opportunities.

Some examples of working capital loans are

Account receivable factoring: If your business has a significant amount of account receivables from its confirmed sales order value, then you can raise a loan against it. The lender generally offers loan deducting a percentage amount and takes over the collection.

Trade creditor: The loan is provided by the supplier and is generally offered when you place a bulk order from them. However, before offering you a trade creditor working capital loan, the supplier will review your company's credit history and past dealings. 

Equity funding: A popular mode of financing among startups, this loan is generally raised against personal resources. Equity loans are the most suitable financing option when you do not have a significant credit history or a good credit score. 

Conclusion

Now that you know what a business line of credit offers and how you can use a working capital term loan, it is time to raise funds to meet all your working capital needs. With the right type of loan, you can ensure that the daily operations of your business run smoothly and it continues to thrive in the competitive markets of today.