Style of credit

Commercial banks finance working capital requirements of their customers. The main style of
credit or systems of financing prevalent in our country are:

 Cash credit system

 Overdrafts
 Loan system
 Purchase and discounting of bills

The terms and conditions; the right and privileges of borrower and banker differ in each case.
1.Cash credit system
The cash credit system is a financial arrangement offered by banks to eligible customers,
typically businesses, enabling them to access funds up to a predetermined limit. This system
facilitates short-term borrowing for operational needs, such as purchasing inventory, paying
suppliers, or covering other day-to-day expenses. Unlike traditional loans, where the entire
amount is disbursed upfront, cash credit allows borrowers to withdraw funds as needed, paying
interest only on the amount utilized. This flexibility can be advantageous for managing cash flow
fluctuations. Additionally, cash credit facilities are often secured by collateral, such as inventory,
accounts receivable, or property, to mitigate the lender’s risk. Overall, the cash credit system
provides businesses with a convenient and flexible financing option to support their ongoing
operations and growth initiatives.
Key Features of Cash Credit

Type and Nature of the Loan: As previously stated, a cash credit facility is a short-term loan
given to businesses to cover their working capital requirements. It is a type of secured loan. It
can be processed more quickly than unsecured loans.

Tenure: A borrower is granted a cash credit facility for 12 months at once. This tenure can also
get determined every quarter in some situations. This period can get extended according to the
parameters agreed upon by the borrower and the lending bank.

Payback Schedule: The payback schedule for a cash credit facility is very flexible. Borrowers can
return this loan over time via EMIs, either monthly or quarterly, as negotiated by both sides.

Interest Charged: The interest charged on a cash credit facility is lower than the interest
charged on standard business term loans as it does not get charged on the total amount of the
borrowing limit. It only gets applied to the amount borrowed throughout the loan’s term.
Calculation of interest is on the account’s daily closing balance.

Collateral Required: Bank usually requires collateral to lend this facility to businesses. The
borrowing limit, in most cases, is set as a percentage of the available collateral. In most
circumstances, a company’s current or fixed assets, or inventory, are kept as collateral for a cash
credit line.

Charges at the Bank: Even if the borrowers do not use the cash credit facility given by the banks
throughout the loan, the banks levy a fee or charge for providing it to them. This fee is for
money the bank keeps in reserve for the borrower for the cash credit facility, funds that the
bank otherwise would have used elsewhere.

Withdrawals: During the term of the facility or this loan, the business entity can make unlimited
withdrawals.

What Are the Factors of Cash Credit?

Numerous factors decide the borrower’s borrowing limit:

 The borrower’s past track record

 The funds requested by the borrower
 The borrower’s repayment capacity
 The business organisation’s current assets and current liabilities position
 The collateral or security is against the cash credit facility
 The borrower’s credit profile

How Does Cash Credit Work?

A cash credit facility is a type of short-term loan. As a result, cash credit must reflect on the
liabilities side of the balance sheet under the heading Short Term Loans, as per the accounting
rules and Accounting Standards guiding the preparation of the books of accounts and financial
statements.

Suppose Company A is a phone manufacturer that owns and operates a facility where it spends
money on raw materials before turning them into completed goods. In contrast, finished goods
inventory does not get sold immediately. The company’s capital gets trapped in stock. Company
A accepts a cash credit loan in order to pay its expenses. This is done while it waits for its
finished goods inventory to convert into cash, allowing it to continue operating without a
shortfall.

Eligibility for Cash Credit Facility

Cash credit is credit extended to a person more than the amount available in their account, with
interest charged on the cash borrowed. Any of the following people are qualified to take
advantage of this service.

 Individuals
 Partnership Firms
 Limited Liability Partnerships
 Registered Trusts
 Private Limited Companies
 Public Limited Companies
 Co-operative Societies

Documents Required For Cash Credit Facility

The KYC documents, as well as a few additional documents that determine the nature and
sustainability of the firm, are necessary to use this service. Below is a list of documents.

 PAN Card
 Identity Proof of the Applicant
 Address Proof of the Applicant
 Recent Photographs
 Bank Statements
 Application form
 Financial Statements
 ITR and GST Returns
 Business evidence
 Business address proof
 Partnership Deed/ Memorandum and Articles of Association (if applicable)
 Collateral/security information
 Existing loan/liability information
 GST Certificates

Advantages of Cash Credit

Source of working capital financing

A cash credit is an important source of working capital financing, as the company need not
worry about liquidity issues.

Easy arrangement

It can be easily arranged by a bank, provided that collateral security is available to be pledged
and the realizable value of such is easily determined.

Flexibility

Withdrawals on a cash credit account can be made many times, up to the borrowing limit, and
deposits of excess cash into the account lower the burden of interest that a company faces.

Tax-deductible

Interest payments made are tax-deductible and, thus, reduce the overall tax burden on the
company.

Interest charged

A cash credit reduces the financing cost of the borrower, as the interest charged is only on the
utilized amount or minimum commitment charge.

Disadvantages of cash credit system

High rate of interest

The interest rate charged by a loan on cash credit is very high compared to traditional loans.

Minimum commitment charges

A minimum commitment charge is imposed on the borrower regardless of whether the

company utilizes its cash credit or not.

Difficulty in securing

The short-term loan is extended to the borrower depending on the borrower’s turnover,
accounts receivable balance, expected performance, and collateral security offered. Therefore,
it can be difficult for new companies to obtain.

Temporary source of finance

The loan is a short-term source of financing. A company cannot rely on it for an extended period
of time. After the expiration of the loan, it must be renewed under new terms and conditions.

2.Overdrafts

An Overdraft occurs when a person’s bank account goes below zero, the balance is a negative
number – the customer, who is Overdrawn, owes the money to the bank. The negative balance
may be accidental, when the customer draws more money than was available in the account, or
an Arranged Overdraft, which is a prior agreement with the account provider – usually a bank –
with interest charged at an agreed rate.

Even with an agreed overdraft, if the customer exceeds the agreed limit (credit limit), additional
fees may be charged and the interest rates may be higher.

Experts remind people that when they go into overdraft they are getting into debt. It should be
used for short-term borrowing or emergencies only, they add. However, many customers end up
treating their arranged overdraft as their spending limit instead of a last resort.

How does an overdraft work?

Overdrafts let current account users to withdraw money from their bank accounts despite
having a low balance. Banks allow users to withdraw money up to a pre-decided limit. This
might be called your overdraft amount. The overdraft limit is decided on the basis of the
creditworthiness of the borrower. It also considers their income and affordability. Banks charge
a fixed percentage of interest on the amount you have overdrawn.

Sometimes a bank will offer interest free overdrafts. An interest free overdraft allows you to
borrow a little bit without paying any interest. These can be cheaper as there are no interest
payments.

For example, imagine that you have £1000 in your current account and your overdraft limit is
£500. You can make a payment of up to £1500 from your bank account. You will pay a fixed per
cent of interest on the overdrawn amount of £500. If you need to spend more than £1500 you
might need to use an unarranged overdraft. This can help you get more money, but it can also
lead to more debt.

Features of an Overdraft Facility:

The key features of an Overdraft Facility relevant for business owners are:

An Approved Limit of Credit – In business lending by banks, an Overdraft Facility is given to

borrowers according to a fixed limit, which may change from one borrower to another

The Rate of Interest – The interest on a Loan through an Overdraft is only charged based on
amounts used by a borrower

No Charges on Repayment – There is always a charge for repayment on any loan you take.
However, in an OD, there is no such charge that borrowers have to pay

Repayment Anytime – Unlike other loan repayment terms, an OD offering allows you to repay
borrowed amounts at any time. There is no fixed EMI structure. Nonetheless, certain lenders
providing an OD Loan for business may insist that you make payments at certain/specific times.

Types of Bank Account Overdrafts

The two types of bank account overdrafts are authorized and unauthorized overdrafts.

Authorized bank overdraft

With an authorized overdraft, the arrangement is made well in advance between the account
holder and their bank. Both parties agree to a borrowing limit that can be used on all normal
payment methods. Of course, the arrangement comes with a service fee that varies from bank
to bank.

Usually, the fee is charged daily, weekly, or monthly, plus interest, which can be as high as a 15%
to 20% annual percentage rate. Considering the sometimes very high fees, an overdraft
arrangement can be very expensive, especially if the borrowed amount is very small. That is why
account holders should be very careful to avoid overdrafts, even authorized ones.

Unauthorized bank overdraft

As the term implies, this means that the overdraft has not been agreed upon in advance and the
account holder has spent more than his account’s remaining balance. Unauthorized overdrafts
can also happen even if there has been a prior agreement, if the account holder has gone
beyond the agreed overdraft amount. Unauthorized bank account overdrafts incur higher fees,
which makes them more expensive.

Things to Keep in Mind While Availing Overdraft Facility

1.The overdraft will be decided based on the account holder’s balance, so it can be given against
bank FDs, shares and bonds.

2.The rate of interest will be determined based on the nature of your business and the assets
given as collateral.

3.The overdraft facility is just like a loan but in it, you pay interest on the amount used on a daily
basis.

4.An overdraft facility can help you for personal and business purposes like irregular cash flow,
business fluctuations.

5.It is a short term credit facility generally for 12 months, which is renewable after every 12
months.

Eligibility Criteria

 Individual
 Proprietorship Firm
 Limited Liability Partnership
 Public or private limited entries
 Business Vintage for a minimum of 2 years
 Last 12-month current account statement

Advantages of Bank Account Overdrafts

Bank account overdrafts are not always a bad practice. They can carry advantages, including the
following:

Perfect for mismatch of cash

When payment dates arrive before all receivables do, overdrafts are very helpful. For example, a
business keeps only $5,000 in its bank account and three checks amounting to a total of $6,000
need to be paid. In such a case, the overdraft can be used to settle the outstanding check
balances. The account funds will be restored as receivables are paid.
Prevents bouncing checks

Bouncing checks harms one’s credit standing. With a bank account overdraft, bouncing checks is
prevented.

Enables on-time payments

In addition to the previous point, no payments are late due to insufficient funds, because the
overdraft shoulders the deficit. This protects the account holder’s credit score and also helps
them to avoid having to pay late fees to suppliers.

Saves time and paper

Compared to standard long term loans, bank account overdrafts are relatively easy to handle,
requiring minimal paperwork.

Provides convenience

Overdrafts can be made anytime, as needed, as long as the agreement is not withdrawn by the
bank.

Disadvantages of using overdrafts

Each line of credit has its own pros and cons. Even though an overdraft can be beneficial, there
are certain drawbacks to it that one should keep in mind.

Low borrowing limits

An overdraft facility is a useful way of borrowing money. But it cannot replace a regular business
loan. The borrowing limits of an overdraft facility are significantly lower than loans. An overdraft
would be able to cover your operational expenses. However, if you need a huge amount of
funds, say to get new machinery for your business. During such times, bank overdrafts cannot
be of much help.

High interest rates

Bank overdraft facilities are convenient, but they don’t come without a cost. Banks charge high-
interest rates on overdrawn amounts. In fact, in 2020 the Financial Conduct Authority had to
intervene. It asked the banks to explain their high overdraft rates. Banks were charging interest
rates as high as 40% on overdrafts at the time. Currently, the interest rate on an overdraft can
range from 19% to 40%.

Possibility of reduction of the limit

Your overdraft credit limit is controlled by your bank. The bank can reduce the limit according to
the circumstances. Such as if you have too low of a current account balance.
In fact, banks can also withdraw your overdraft facility permanently if required. This is a remote
possibility. One should consider this while assessing the overdraft business advantages and
disadvantages. Banks generally cancel overdraft facilities if the user has not paid back their
overdrawn balance.

The risk of being constantly overdrawn

Users can develop the habit of using their bank overdraft limit constantly without ever paying it
back. The interest cost keeps piling up, and the liabilities keep increasing. This could be called
the overdraft affect.

According to consumer credit insights revealed by the FCA, consumers often do not see
overdrafts as debt. They quickly become habitual to using them. The research also showed that
overdraft users do not actively repay their overdraft. Most repayments are just funds coming
into their bank accounts.

Unauthorised Overdrafts

When you apply to a bank for an overdraft facility, you get an authorised overdraft.
Unauthorised overdrafts are unplanned or unarranged overdrafts. Occasionally, users spend
more than what they have in their business bank account without realising it. This could be
because an unexpected expense paid via direct debits leave your account.

This is called an unauthorised overdraft as there is no pre-existing overdraft arrangement with

the bank. You would be charged an interest on the overdrawn amount by the bank. Banks are
no longer allowed to charge more for an unauthorised overdraft. This should cost you the same
as the arranged overdraft. If you’re the account holder and you use this, it can affect your credit
rating.

Differences between Cash Credit and Overdraft

1.The rate of interest of an Overdraft is higher than that of a Cash Credit. Thus, it is a little more
expensive.

2.A client doesn’t need any guarantee for an Overdraft. Their credit history is enough.

3.Cash Credits are only for business purposes. Overdrafts cover general needs, even on a
personal level.

4.An Overdraft is a document-free process. It can even be availed on existing accounts. A cash
credit, however, needs a new account.
5.The period of an Overdraft loan may be monthly, quarterly, semi-annually or yearly. For Cash
Credits, it is usually 1 year.

3.Loan system

loans system have become an essential part of businesses. In order to increase the growth and
expand the business and also cover the overhead cost every enterprise need fund, for that
purpose, lending and borrowing have become seemingly common in every business.

There are various types of loans that are available to meet individuals’ financial needs. Bank
loan benefit is that they are also a reliable method of financing a small business.

Business owners should weigh the advantages and disadvantages of bank loans against other
means of finance. They should examine whether the loan is good or bad.

What are the Factors of loan system:

How you will use the loan

Lenders want to make sure you’re using the right product for your needs. Options may include
small business credit cards, which are designed to help you manage day-to-day expenses; a line
of credit, which is generally used for short-term working capital needs; and a commercial term
loan, which is best for financing larger investments over time.

If you’re not sure which type of financing you need, ask your banker for advice. “They can help
you look at different options and decide the best one for your situation,” says Roderick Wilson,
Small Business Lending Product executive with Bank of America.

The amount of financing you’re seeking

Attempting to borrow more than your business can afford is a red flag to lenders. Lenders may
also question the application if you don’t borrow enough for your demonstrated need. “If a
doctor is applying for a loan for a new practice but isn’t including the office build-out, they
could end up cash-strapped. It may make sense to borrow those additional funds, so they have
more cash on hand in the short term,” Wilson says. Seek advice from your accountant or banker
on how much to borrow.

Your business and personal credit profile

When you submit your credit application, lenders will typically look at both your business credit
and your personal credit standing. “You’re almost always going to have to sign a personal
guarantee on a small business loan,” Wilson says. A personal guarantee is a legally binding
promise to repay money — from your personal assets — that your business has borrowed.

Before you submit a credit application, review both your personal and business credit reports
for delinquent accounts (or incorrectly reported delinquencies) with all major credit reporting
agencies. Business credit reporting agencies include Dun & Bradstreet, Experian and Equifax;
you can check your personal credit reports with Experian, Equifax and TransUnion. If there is any
negative information in your credit report, submit an explanation so the lender can better
understand the situation.

Your capacity to repay

Your application should also demonstrate your ability to pay back borrowed money. “A lender
may ask for at least two years of personal and business tax returns, a debt schedule that
includes details of all of your business debts, and personal financial statements,” says Chris
Ward, Small Business Credit executive with Bank of America. He adds that lenders now might
also ask for year-to-date profit-and-loss and balance sheet statements, “in order to understand
how your business has been doing recently, especially in light of the added challenges many
companies are facing due to the current economic environment.”

You might also need to show business and personal assets, as well as cash reserves. Lenders
often want to know about your business’s capital assets, such as cash and equipment, and
about any funds that others have invested in your business. If you are applying for a loan that is
secured by collateral, a lender might ask for details about your accounts receivable, inventory,
equipment and commercial real estate

Advantages of loan system

Flexibility:- A loan allows one to repay as per convenience as long as the installments are
regular and timely. Unlike an overdraft where all the credit is deducted in a go, or a credit card
where the maximum limit can not be utilized in one go.
 Tax benefit:- Interest payable on the loan is made by the government tax deductible item when
the loan has been taken for business purposes.

Cost effectiveness:-When it comes to interest rates, bank loans are usually the cheapest option
compared to overdraft and credit cards.

Profit retention:- The profit raised in the bank loan need not share with the bank while when
you raise funds through equity you have to share profits with shareholders.

Disadvantages of loan system:-

Hard prerequisite:- Since big finance from a bank is based on collateral, most young businesses
will find it hard to finance their operations based on a bank loan.

Security needs and creditworthiness:- In order to avail of a bank loan you should have a sound
credit score or valuable asset otherwise it is extremely difficult to obtain a loan. Also, banks are
incredibly vigilant to lend money, they only give loans to borrowers who have the ability and
willingness to repay the loan.

Strict repayment schedule:- Banks prescribe a very strict repayment schedule to the borrower,
which must be adhered to. Failure to do so may affect borrowers’ future credibility and credit
score.

Processing charges:- For sanctioning a loan, most banks charge a processing fee which adds to
the cost of your loan. This is normally charged in the terms of a percentage. The higher the loan
amount, the bigger the percentage of the processing fee is.

Strict eligibility criteria:- Another disadvantage is that banks are very cautious about lending
loans to small businesses and start-ups. Their strict lending criteria can make it particularly
difficult for start-ups and newer businesses to be accepted for a loan as they don’t have the
financial or trading history to back up their application and if they are accepted the interest
rates are likely to be increased to compensate for the added risk.
 4.purchase and discounting of bills

Bill purchase, also known as purchase bill, is a financial instrument used in trade finance. It
involves a seller (drawer) issuing a bill of exchange to a buyer (drawee), who agrees to pay the
specified amount at a future date. The seller can then sell this bill to a bank or financial
institution at a discount, receiving immediate cash. The bank will collect the full amount from
the buyer when the bill matures. It’s a way for sellers to access funds quickly while allowing
buyers to defer payment. On the other hand, Bill discounting is a financing technique where a
seller (drawer) receives immediate cash from a bank or financial institution by selling a bill of
exchange at a discount. The seller discounts the bill before its maturity date, receiving a lower
amount of cash upfront, and the bank collects the full face value of the bill from the buyer
(drawee) when it matures. It’s a common method used by businesses to access funds quickly,
especially when they have receivables pending from customers.

Key Differences Between Bill Purchase and Bill Discounting

Bill discounting involves the bank providing funds to the seller based on the discounted value,
while bill purchase involves the bank purchasing the bill from the seller for the purchase price.

In bill discounting, the seller is still responsible for collecting payment from the buyer when the
bill matures, whereas, in bill purchase, the bank assumes the responsibility of collecting the
payment.
Bill discounting involves deducting a discount from the face value of the bill, while bill purchase
involves buying the bill at a price lower than the face value.

Both bill discounting and bill purchase offer sellers immediate funds, but the main difference
lies in who takes the responsibility for collecting payment and the financial arrangement
between the bank and the seller

How Do They Work: Bill Discounting vs Bill Purchase?

Invoice Discounting

Your business prepares invoices against the credit sale of goods or services. You share the
invoice details and corresponding bills with your lender. This institution assesses the invoices
and provides cash advances at a discounted rate against their value. Your business’s credit
controller then sets to collect payments from the debtors. When the invoices are settled, you
repay the lender such a loan amount. The cash advance you receive via the bill discounting
facility does not involve any spending constraints. Thus, you can channel this fund for any
purpose, like paying suppliers, undertaking a new venture, etc.

2. Bill Purchase

Invoice is generated against the sale of goods and services on credit. You sell the bills to the
factor.

This financial institution analyses the invoices and provides a percentage, let’s say 80% of their
value as a cash advance. Such a lender then initiates the payment collection process. When
your customers or debtors clear up payment, the factor forwards you the remaining 20% of the
invoice value, minus the service fee or interest. Similar to bill discounting, there’s no end-use
restriction involved with the invoice factoring facility.

Pros And Cons Of Bill Discounting And Purchase

Some common advantages of both these financing options are:

 They provide access to instant financing without any collateral.

 Businesses can streamline their cash flow with ease and efficiency, especially if credit
terms vary across clients.
 They do not encumber the finances of a business.

Apart from this, when considering whether to go with bill discounting or purchase, take a look
at the following points
Customer Relationship

With bill discounting, you undertake the responsibility of outstanding payment collection from
your customers. Since it is confidential, your customer relationship remains unaffected. In the
case of bill factoring, the lender collects the outstanding payment. Thus, your customer
relationship may be affected.

Payment Collection

Your business may benefit from the expertise of a lending institution in terms of payment
collection, but that may not always be the case. Thus, you may opt to go with bill purchases if
you think their payment collection process can be more effective than otherwise. On the other
hand, you might choose to stick with bill discounting if you wish to retain the responsibility to
collect payments from debtors.

Now that you are aware of the points of difference between bill purchase and bill discounting
and its implication on your business, it’ll be easier to decide which invoice financing option will
maximize your benefits.

Bottomline

In conclusion, the main difference between bill discounting and bill purchase lies in the financial
arrangement and responsibility for collecting payment.

In both cases, sellers receive immediate funds, but bill discounting requires the seller to collect
a payment, while bill purchase transfers the responsibility to the bank. The choice between
these methods depends on the seller’s preference, financial needs, and the terms offered by
the financial institution.