This article explores the significant differences between an overdraft and a working capital loan. Read on!
The main difference between an overdraft facility and working capital is the former lets you withdraw money from your bank account even if your balance is zero, whereas the latter helps you get business loans to carry out your regular business functions like advertising, and sales, marketing, etc.
If an account holder wants to withdraw more money than is available in his bank account, he can use an overdraft facility. So, what exactly is this overdraft? And is there any difference between an overdraft facility and working capital loans?
If you are not too sure, then this article will help you understand the difference better! It is interesting to note that an overdraft facility can drive a business even when the balance is zero. Thus, an overdraft facility is a short-term credit facility offered by a bank or other financial institution.
What is an Overdraft?
An overdraft is essentially a loan that the bank permits its clients to take out up to a certain amount of money. Each overdraft incurs fees. It is an extension of credit from the financial institution that is granted when an account reaches zero. Even when there are no funds in the account or not enough to meet the withdrawal amount, the overdraft enables the account user to keep making withdrawals.
Thus, the overdraft facility saves the account holder from a cheque being bounced. It gives the account holder short-term relief when facing financial difficulties. The interest rate on overdraft amounts is generally lower than that on credit cards. Mismanagement of overdraft facilities might cause a legal issue for the bank account holder.
In addition to that, the banks offering overdraft facilities can temporarily choose to use their funds to cover the overdraft amount. It may also link it with account holders’ credit cards if required. However, the overdraft amount taken from any bank can increase the risk of credit against the account holder at any given point in time. For failing to pay back overdraft money on time. Simultaneously he should be liable to face the legal consequences.
Eligibility Criteria for Availing Overdraft Facility
- Applicants must be at least 21 years old and no more than 65 years old
- Applicants must hold an existing bank account with the relevant bank
- Criteria for income eligibility vary among lenders
- Positive CIBIL or credit score will be beneficial
- Requirements regarding the duration of business existence vary depending on the bank.
Benefits of Overdraft Facility
- Cash can be utilised flexibly in small increments
- Meets immediate cash needs during crunch situations
- Assists in business cash flow management
- Interest is charged solely on the amount used
- Streamlined paperwork process
- No need for collateral with banks/NBFCs
- Short-term borrowing, subject to annual review.
What is a Working Capital Loan, and How is it Different?
Every business needs to incur many running costs, irrespective of revenue earnings or sales volume. Sales or revenues may vary from time to time. But a company has to bear the costs of overheads. Working capital refers to capital associated with work in progress. For instance, the employees’ monthly wages and other liabilities are part of working capital.
Seasonal businesses have more significant overheads, and operational costs can be heavy during leaner periods. Therefore, working capital is directly related to any industry’s functional aspect. On the other hand, an overdraft fee can only be given when the business owner is suffering from a temporary bankruptcy. Therefore, overdraft fees can only be sanctioned at the bank’s discretion.
To carry on its business and continue with uninterrupted service, sometimes a company may take loans known as working capital loans. Financial institutions may or may not ask for collateral for issuing such loans depending on the business’s critical factors. But, for sanctioning such loans, financial institutions assess the business’s financial health. At the same time, loan disbursals of this kind can be directly related to the liquidity quotient of the concerned brand.
Thus, Working Capital Loan is not issued for business expansion or to finance the purchase of new assets. The purpose of giving such a loan is to enable the business to continue its operation when the company cannot meet its day-to-day expenses from current income sources. Thus, a working capital loan provides a short-term relief mainly to the seasonal business or any other business with cyclical sales.
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Who Can Avail from the Working Capital Loan?
Now that you have got a fair idea about the working capital loans, are you eligible to opt for one? For that matter of fact, the working capital loan is typically availed by short and medium-sized business owners. Banks charge an amount that varies from one institution to the other. Several factors determine the interest rate and the maximum permissible loan amount. Here are a few listed below:
- Size of the business
- The present financial health of the business and risk-taking capabilities
- Previous years’ business performance primarily net profits
- Business turnover in the recent years.
Also note:
- Interest rates will depend on the amount of loan taken whatsoever
- The duration for which the loan is sanctioned also is taken into consideration
- Collaterals (optional)- like gold, property, investment in other businesses etc.
- An overall Credit score of the business.
In addition to the above, financial institutions will thoroughly conduct a requirement analysis while determining the maximum permissible loan amount. The following aspects are taken into consideration while assessing requirements:
- It will also take into account how long the business has been operating
- If the business has taken loans previously, before getting the new loan sanctioned, the financial institution will go through the credit history of the concerned company. Decisions for loan sanctions will be taken based on several aspects
- The applicant seeking a loan has to be above 21 years but below 65 years.
How to Calculate Working Capital Loan
Working capital is determined by subtracting current liabilities from current assets. Thus, the formula to compute working capital is as follows:
{Working Capital} = {Current Assets} – {Current Liabilities}
Benefits of Working Capital Loan
A Working Capital Loan caters to the daily operational and short-term financial needs of the business, here are some of the benefits of Working capital loan:
- There are no restrictions on how the funds can be used
- Prompt approval of working capital loan applications and prompt payment or drawdown
- Loan granted without collateral based only on the company’s qualifications
- An affordable interest rate and a short term of about a year
- Minimal paperwork is required, and the disbursal process is fast
- The loan amount is available for day-to-day business operations.
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How to Calculate the Overdraft Facility?
If a business has a time gap between its investment and realisation of revenue, it may find it difficult to finance its working capital. In that case, it may like to use overdraft facilities offered by the bank account. Applying for an overdraft facility, the borrower must thoroughly understand and conduct its requirement analysis by examining the business operating cycle. After doing that, the business owner should appeal to the bank to extend its overdraft limit.
On the other side, the bank will also evaluate the borrower’s appeal after thoroughly examining the business credit history, verifying and validating its operating cycle, overall business performance, turnover in recent years, outstanding loans, history of solvency etc.
Conclusion
All said and done, overdraft facilities are made to be special considerations when a business reaches bankruptcy. On the other hand, working capital loans can be easily sanctioned depending on the operational costs of a company running successfully. Both the loans are quite different, although such amounts are approved under the bank’s disclosure. We hope you have now understood the difference between the two in detail.
Frequently Asked Questions
What is the difference between a loan and an overdraft?
n overdraft option is a form of credit which is offered to an individual or organisation based on a current account. In addition, the amount which is withdrawn varies depending on the customer’s requirement. However, a regular loan talks about a fixed amount that is borrowed from a specific bank highlighting a stated repayment duration
What is the difference between Working Capital and Overdraft?
When all is considered, overdraft facilities are reserved for special circumstances, typically when a business faces bankruptcy. Conversely, working capital loans can be readily approved based on a company's successful operational costs.
What is the formula for calculating working capital?
There are three working capitals that are calculated using the following formulas: Working capital = current assets – current liabilities. Net working capital = current assets (minus cash) - current liabilities (minus debt). Operating working capital = current assets – non-operating current assets. Non-cash working capital = (current assets – cash) – current liabilities.
What is the example of working capital?
If a company has current assets of ₹200,000 and current liabilities of ₹180,000, then its working capital would be ₹20,000
Who uses working capital?
Working capital refers to the funds used to address a company's immediate financial obligations, typically those payable within a year.
Who would use an overdraft?
Financial institutions provide overdraft facilities that are accessible to savings or current account holders, as well as to salaried individuals, chartered accountants, business owners, doctors, and bank employees.
Why do people get overdraft facilities?
It assists the business proprietor with managing cash flow for meeting their daily operational expenses. With the overdraft option provided by their Current Account, holders can easily cover pending payments using checks or pay orders.
