Introduction
Money and timing are both essential elements for any business firm. This is because money fulfils the short-term and long-term requirements of finance. Since the business owner can't bring all the finance required by the company, they turn to loans and advances. Both loans and advances are liabilities that need to be paid off. Although a layman uses both terms interchangeably, they are vastly different. It is essential for a business person to know about both these sources of borrowed funds for the firm to operate successfully and resolve financial crunches effectively and efficiently. A loan refers to a debt provided by a financial institution for a specific period. An advance, on the other hand, is the fund that is provided by commercial banks to a business firm to fulfil its working capital requirement. Advances are to be paid within one year of obtaining the funds. This article attempts to explain the concepts of loans and advances in detail. Further, it also aims to demonstrate the key differences between the concepts in a tabular format and in points.
Loans vs Advances
The critical difference between a loan and an advance is that loans are granted by banks and must be returned with interest. In contrast, an advance is an early payment from the salary of an individual or pay received from a buyer of goods in advance. A loan is a debt that needs to be repaid, while an advance is a credit facility availed. While a loan is generally granted for long-term purposes, an advance is usually granted for a shorter period. Obtaining a loan involves various legal formalities and rules and regulations.
On the other hand, getting an advance requires a comparatively lesser amount of paperwork and documentation. Loans are repaid to the lender by the borrower while an advance is deducted from the following payment due to the borrower. Interest is payable on a loan, while advances generally do not involve the amount of interest. Loans are usually granted by financial institutions and commercial banks, while advances are given by employers or buyers of goods. Loans are granted against collateral and written agreement, while advances are given without any collateral security and generally do not involve any written agreement. A loan is typically a significant amount of money, while an advance is usually a smaller sum.
Difference Between Loans and Advances in Tabular Form
| Parameters of Comparison | Loans | Advances |
| Definition | A loan is defined as a debt that is provided by a financial institution for a specific period. | An advance is a sum of money obtained by a firm or an individual before performing the service or supplying the goods. |
| Duration | Loans are generally provided for a long duration, and it may be more than a year, three years or even five years. | Advances are generally provided for a shorter duration of time, generally lesser than a year. |
| Repayment obligation | The borrower is lawfully obligated to repay the amount of loan obtained along with interest payable, and it may be repaid in a lump sum or as instalments. | An advance is deducted from the salary of the employee. In the case of a firm, it may be subtracted from the following payment. It may be deducted as a whole amount, or in instalments spread over months, or a financial year. |
| Interest payment | A loan carries a specific amount of interest to be paid along with the principal amount, which is determined at the time of receiving the loan. | Advances typically do not carry any interest that must be paid. |
| Essence | A loan is essentially a debt that must be repaid | An advance is a credit facility availed. |
| Documentation | Granting a loan involves various formalities and legal paperwork that must be completed. | Granting of an advance does not involve any legal formalities or paperwork. Advances are often given with a by-word agreement. |
| Collateral security | Loans are usually granted against the security of some collateral for safety. | The individual obtaining the advance is the collateral in case of receiving an advance. There is no other collateral security that needs to be pledged. |
| Lender | The lender is typically a financial institution or commercial bank. | The lender is the employer or buyer of goods and services. |
| Amount | Loans granted usually involve large amounts of funds. | Advances are typically granted for smaller amounts of funds. |
What are Loans?
A loan is defined as a debt that is provided by a financial institution for a specific period. Loans are generally offered for a long duration and usually involve large amounts of funds. The lender is typically a financial institution or commercial bank. The borrower is lawfully bound to repay the amount of loan obtained along with interest payable. It may be repaid in a lump sum or as instalments. A loan carries a specific amount of interest to be paid along with the principal amount, which is determined at the time of obtaining the loan. Granting a loan involves various formalities and legal paperwork that must be completed. Loans are usually granted against the security of some collateral for safety.
Types of loans based on:
- Security
- Secured Loan: Loan that is backed by a collateral security
- Unsecured Loan: Loan that is not backed by any collateral security.
- Repayment
- Demand Loan: Loan which is repayable on demand.
- Time Loan: Loan that is repaid on a pre-determined specific date in the future
- Instalment Loan: Loan that is repaid in equal instalments over the loan period.
- Purpose
- Home Loan- Loan granted for purchase or construction of a house.
- Car Loan- A car loan is a loan that is granted for the purchase of a car.
- Education Loan- Educational loan is a loan that is granted for education. These are typically repaid when the beneficiary of the loan is employed.
- Commercial Loan- The loan amount is used for commercial purposes.
- Industrial Loan- The loan amount is used for industrial purposes.
Merits of Loans
- Banks provide timely assistance to businesses by offering loans as and when required.
- Secrecy of the business firm can be maintained since information supplied to the bank by the borrowers is kept confidential.
- A loan from a commercial bank is a flexible source of finance. This is because the loan amount can be increased as per the business requirements and can also be repaid in advance when excess funds are available with the business.
- Since repayment of the loan can be made in instalments, it does not prove to be a financial burden on the business entity.
- The funds are available for borrowing even during periods of depression when other sources of finance are not available.
Limitations of Loans
- Funds are generally available for limited periods, and their extension or renewal is uncertain and complex.
- Banks undertake detailed investigations of the company's affairs, financial structure and other matters. They may also ask for the security of assets and personal sureties. This makes the procedure of obtaining funds slightly tricky.
- In some cases, complex terms and conditions are imposed by banks. For the grant of loan. For example, restrictions may be imposed on the sale of mortgaged goods, thus making regular business working difficult.
- Banks and financial institutions follow rigid criteria for grants or loans. Too many formalities make the procedure time-consuming and expensive.
What does the contract for the loan include?
The terms of a loan are mutually agreed upon by each party involved in the transaction before any exchange of funds takes place. This contract typically includes the
- The amount lent out.
- The amount to be repaid.
- The number of instalments that the loan is repaid in
- The repayment period,
- And collateral (if any).
- Interest amount charged.
What are Advances?
An advance is a sum of money obtained by a firm or an individual before performing the service or supplying the goods. The lender is the employer or buyer of goods and services, and advances are typically granted for a small number of funds. They are usually provided for a short duration of time, generally lesser than a year. An advance is deducted from the salary of the employee. In the case of a firm, it may be subtracted from the following payment. It may be deducted as a whole amount, or in instalments spread over months, or a financial year. They typically do not carry any interest that must be paid. An advance is a credit facility availed. Granting of an advance does not involve any legal formalities or paperwork. Advances are often given with a by-word agreement. The individual obtaining the advance is the collateral in case of receiving an advance. There is no other collateral security that needs to be pledged.
Merits of Advance
- It is a convenient and continuous source of funds
- It may be readily available in case the credit worthiness of the firm is known to the seller.
- It does not impose any charge on the assets of the corporation while providing funds.
- No interest payment
Limitations of Advance
- The availability of accessible and flexible advances may induce a firm to indulge in overtrading, which may add to the risks to the firm.
- Only a limited amount of funds can be generated through this method.
Main Differences Between Loans and Advances In Points
- A loan may be defined as a debt provided by a financial institution for a specific period. While an advance is just a sum of money obtained by a firm or an individual before performing the service for which they are being paid.
- A loan is a debt that must be repaid on a specified date, while an advance is a credit facility that is availed before rendering the service.
- Loans are typically provided for a long duration, while advances are typically offered for shorter periods, usually not more than a year.
- The borrower is legally bound to repay not only the entire amount of the loan but also a pre-determined interest amount. However, an advance is deducted from the salary of the employee or subtracted from the following payment in the case of an enterprise.
- A loan is to be repaid at a particular rate of interest, which is determined at the time of obtaining the loan. On the other hand, advances do not carry any interest rate that must be paid along with the principal amount.
- Even applying for a loan involves various formalities and paperwork to be completed. However, receiving an advance does not include any legal formalities or paperwork since they are given to people whom the lender personally knows. Advances may also be granted according to a by-word agreement alone, even without collateral, while collateral is the foremost requirement to grant a loan.
- The lender is a financial institution or commercial bank in case of a loan, while it is the employer or buyer of goods and services in case of an advance.
- Loans are generally borrowed for a large number of funds, while advances are given for smaller amounts of funds that can be comfortably deducted from the employee's salary without putting a great financial burden on them.
Conclusion
Loans and advances are sources of meeting the financial requirements of individuals and business firms. They are both liabilities that need to be repaid in different ways. However, they are essentially different in terms of duration, the amount granted, lender, interest payment obligation etc. A loan refers to a debt provided by a financial institution for a specific period. An advance, on the other hand, is the fund that is provided by commercial banks to a business firm to fulfil its working capital requirement. Advances are to be paid within one year of obtaining the funds. This article has attempted to demonstrate the critical differences between loans and advances. It has explained the concept of a loan, its merits and limitations and its types based on security, purpose, and repayment.
Further, it has described the concept of advances in detail and outlined its merits and demerits. A business entity must analyse both these avenues of debt financing before making an informed choice between the two. Both are forms of debt accumulation that the business must be careful about to maintain flexibility to borrow funds in the future.
References
- www.fullertonindia.com
