Term Loan vs Working Capital Loan: Match the Debt to the Use

Many loan requests go wrong before the bank opens the file, because the promoter asks for money without saying what it will do. Banks do not lend in general. They lend against a use, and the use decides the product, the tenor, the security and how the limit is sized.

The two products every Indian business meets first are the term loan and the working capital loan. This guide explains what each one is for, how banks size them, the costly mistake of mixing them up, and what to prepare before you apply.

What each loan is meant to fund

A term loan is repaid in fixed instalments over several years out of the profits the asset helps to earn. It suits capital expenditure: machinery, a factory shed, a new branch, a technology platform or buying a business.

A working capital loan funds the trading cycle: raw material, work in progress, finished stock and money customers owe you. It comes as cash credit, overdraft, demand loan or bill discounting, plus non-fund limits such as letters of credit and bank guarantees. Limits are usually renewed every year after review, and what you can draw moves with your stock and debtors.

The rule is simple: match the life of the loan to the life of the asset. Long-lived assets need long-tenor money; a short cycle needs revolving money that rises and falls with the business.

How a bank sizes a working capital limit

For micro and small enterprises, RBI's turnover method treats about 25 percent of projected annual turnover as the working capital need, with the bank financing at least 20 percent and the promoter bringing about 5 percent. It applies to fund-based limits up to Rs 5 crore under RBI's MSME lending directions.

For larger limits many banks still use the second method of lending from the old Tandon Committee framework: the promoter funds at least 25 percent of total current assets from long-term money and the bank finances the rest of the gap. That is where the familiar minimum current ratio of 1.33 comes from.

Once the limit is sanctioned, what you can actually draw is your drawing power, worked out from the monthly stock and debtor statement: paid stock less the stock margin, plus eligible debtors less the debtor margin. Margins sit in your sanction letter, commonly around 25 percent on stock and higher on debtors, and debtors older than the age limit, often 90 days, are excluded.

How a bank sizes a term loan

A term loan is sized backwards from repayment capacity. The bank projects your cash accruals and checks the debt service coverage ratio, or DSCR: profit after tax plus depreciation plus term loan interest, divided by that interest plus the principal due in the year. Many lenders want an average DSCR of roughly 1.25 to 1.5, and they look just as hard at the weakest year.

The bank also expects a real promoter contribution, often around 25 percent of project cost or more depending on the sector, and security cover, the value of assets charged against the loan, commonly 1.25 to 1.5 times the loan. Personal guarantees from promoters are normal for private companies.

A moratorium, a period at the start with no principal repayment, should match the time the asset needs to start earning. Too short, and instalments arrive before the cash does. Too long, and you pay interest on money that is not yet working.

The costly mistake: funding capex from cash credit

The most common error in a growing business is buying machinery out of the cash credit limit because it is already sanctioned and quick to draw. The asset takes years to pay back, but the limit was sized for stock and debtors. The account runs full, the balance overtakes drawing power, and nothing is left for real working capital.

Banks watch for this. Under RBI's norms, a cash credit that stays above its drawing power or limit becomes SMA-1 after 30 days, SMA-2 after 60 days and a non-performing asset after 90 days. Rating agencies can treat a cash credit overdrawn for more than 30 days as a default. Either outcome hurts your next renewal.

If capex has already been funded this way, ask the bank to carve the stuck portion out into a working capital term loan or a proper term loan while the account is still regular. It is much harder to negotiate after the account has slipped.

Where other debt products fit

External commercial borrowing lets eligible Indian companies borrow from overseas lenders, including a foreign shareholder, within RBI's rules on end use, maturity and cost. RBI has been revising that framework, so check the current Master Direction before you plan one.

Non-convertible debentures suit larger, rated companies that need bullet or structured repayment a bank will not offer. Bill discounting and TReDS turn receivables from large buyers into cash. None of these change the basic match: long assets need long money, and a short cycle needs revolving money.

Security, pricing and the MSME angle

Working capital limits are usually secured by hypothecation of stock and debtors, and term loans by a charge on the asset financed, often with property as collateral on top. Floating-rate loans to micro, small and medium enterprises are linked to an external benchmark such as the repo rate plus a spread, so compare spreads and charges, not headline rates.

RBI bars banks from taking collateral on loans up to Rs 10 lakh to micro and small enterprises. CGTMSE guarantees eligible loans, and its ceiling was raised from Rs 5 crore to Rs 10 crore in 2025. The guarantee fee is often passed on to the borrower, so compare it with the cost of offering collateral.

A checklist before you apply

Write one page that says what the money is for, how much, over what period, and where repayment will come from. That page decides whether you need a term loan, a working capital limit or both.

Then assemble the file the bank will ask for anyway.

• Recent audited financial statements and provisional figures for the current year
• Projections with written assumptions, and a CMA data report if the bank uses that format
• For capex: quotations, a project cost break-up and proof of your own contribution
• For working capital: holding periods for stock, debtors and creditors, and a debtor ageing
• Sanction letters, repayment track record and your commercial credit report

Frequently asked questions

Can I use a term loan for working capital?

Yes, through a working capital term loan, which covers the permanent core of working capital or regularises an overdrawn account. It is repaid in instalments, so size it to your real cash generation, and keep a properly sized cash credit limit alongside it.

Which is cheaper, a term loan or cash credit?

It depends on the bank, your credit profile and the security. On cash credit you pay interest only on what you use; a term loan charges interest on the full outstanding balance but gives certainty. Compare the spread, the processing and renewal charges and the collateral asked for.

How much working capital limit can my business get?

For micro and small enterprises, banks often start with the turnover method, about 25 percent of projected annual turnover, with the bank financing about 20 percent. Larger limits are assessed on projected current assets and liabilities in a CMA report, and what you can draw is always capped by drawing power.

Do I need collateral for a business loan in India?

Not always. RBI bars collateral on loans up to Rs 10 lakh to micro and small enterprises, and CGTMSE cover can support collateral-free loans above that for eligible borrowers. For larger loans, banks usually take a charge on the assets financed plus collateral and personal guarantees.

Related guides

• Working Capital Loans: CC vs OD vs WCDL
• Project Finance for Indian Capex: Bankability, DSRA and Drawdown
• External Commercial Borrowing: RBI's Automatic Route
• Debt syndication and credit rating services