There are many ways to raise finance; Cash Credit is one of the many ways of raising finance. Cash Credit makes a provision by lender (mainly bank or financial institute) for loan (also called advance, finance, credit etc) by depositing the sanctioned amount of the loan into new account from which borrower (business organization) can withdraw as per requirement within permissible amount fixed by lender for specific time or period.
Example: - say, ABC Ltd needs ` 1,15,000 for payment to supplier of raw materials. Bank permits `1,00,000 per day as cash credit limit for this period. In this situation ABC Ltd can withdraw only `1,00,000. Interest also calculated on ` 1,00,000 on daily basic, not on ` 1,15,000.
Cash credit theory based on “Pay on Demand”. Cash Credit arrangement is one type of short term loan or finance or advance raised by Bank or Financial Institute to business organization. Cash credit facilities fulfill the requirement of working capital which is needed to run daily operation in a business concern. It is similar to loan but different from conventional loan. In this system, Bank or Financial Institute maintain a Cash Credit Account for their borrower. Cash credit makes a provision for credit by transferring the sanctioned amount into Cash Credit Account from which borrower can withdraw as per their requirement. Borrower can withdraw money within sanctioned “limit” & “daily limit”. Cash Credit Account almost similar to Current Account but it’s not Current Account. In cash credit system, interest charged on amount actually withdrawn in daily basic. Borrower can’t withdraw total sanctioned amount of loan at a time.
Bank or Cash Credit provider holds Stock or Book Debt (as security) against advance sanctioned. The security or guarantee remains accessible by advance provider (normally Bank) until Cash Credit repaid in full. Depending on the security holds, Cash Credit facility is two types i.e. Pledge (where Bank or Financial Institute holds physical control of stock & book debt.) & Hypothecation (borrower holds total control of stock and submits periodical statement of stock to the lender). Cash Credit-Hypothecation system is broadly used.
Cash credit amount is pre-approved and the repayment of loan is the same whether borrower is using cash credit or not. If cash credit amount is paid off before term of loan is complete, borrower is liable to pay penalty fee based on % of loan amount.
Characteristic of Cash Credit Facilities:-
- It’s one type of short period (more period than overdraft) finance or loan.
- Cash Credit facility is a provision to create loan or advance or credit by lender (mainly bank or financial institute) to borrower (mainly business concern)
- It’s used to fulfill working capital requirement which is needed to run trading operation in a business. Only business concern can enjoy this facility. Working Capital = Current Assets – Current Liabilities.
- Business concern can enjoy Cash Credit facility against Pledge or Hypothecation of stock, book debt as a security or guarantee of the finance.
- Advance is sanctioned & money transfer to Cash Credit account by Bank or Financial Institute.
- Borrower can withdraw money from Cash Credit account within permissible amount fixed by Bank for specific period.
- Borrower can’t withdraw total loan amount at a time.
- Interest charged amount actually withdrawn in daily basic, not full loan amount. Bank can charge certain amount on portion of loan not used by business concern because bank can’t use cash credit sanctioned amount.
- Bank is not funded total required working capital. Some portion of working capital is invested by the business entities himself & balance amount is supply by bank in way Cash Credit.
Purpose of Cash Credit:-
Main purpose of cash credit facility is to fulfill the requirement of working capital. Working capital is needed to run daily trading & business operation in a business concern.