Cash credit is a short-term financing arrangement provided by financial institutions, such as banks, to businesses for meeting their working capital requirements. It is a type of secured loan where the borrower can access funds up to a specified limit, based on the value of their current assets, such as inventory and accounts receivable. The interest is charged only on the amount utilized and not on the entire sanctioned limit.
Importance of cash credit:
- Liquidity: Cash credit provides businesses with immediate access to funds, helping them maintain liquidity and manage cash flow effectively.
- Flexibility: Unlike term loans, businesses can draw, repay, and redraw funds within the cash credit limit as per their needs.
- Lower interest cost: Since interest is charged only on the utilized amount, businesses can potentially save on interest costs compared to other forms of credit.
Types of cash credit:
- Pledge: The borrower pledges inventory or goods as collateral for the loan. In case of default, the lender has the right to sell the pledged goods to recover the loan amount.
- Hypothecation: The borrower hypothecates inventory, receivables, or other assets as collateral, but retains possession of the assets. The lender has the right to take possession of the hypothecated assets in case of default.
Formula on cash credit:
Cash credit limit is generally calculated based on a percentage of the borrower’s current assets, such as inventory and accounts receivable. The formula is:
Cash Credit Limit = (Inventory * %) + (Accounts Receivable * %)
The percentage values may vary based on the lender’s policies and the borrower’s creditworthiness.
Examples of cash credit:
- A manufacturing company needs funds to purchase raw materials for production. It applies for a cash credit facility, pledging its inventory as collateral. The bank approves a cash credit limit, allowing the company to access funds as needed to maintain production.
- A retailer faces seasonal fluctuations in sales and requires funds to manage its cash flow. It obtains a cash credit facility based on the value of its accounts receivable, helping it manage working capital effectively during peak seasons.
Issues and limitations of cash credit:
- Collateral requirement: Cash credit facilities require businesses to provide collateral, which may not be feasible for startups or companies with limited assets.
- Overdependence: Relying heavily on cash credit may lead to an overextension of credit, resulting in cash flow issues and potential insolvency.
- Monitoring costs: Lenders need to closely monitor the borrower’s financial performance and collateral value, adding to the overall cost of the credit facility.
- Misuse of funds: Borrowers may use cash credit funds for purposes other than working capital, leading to financial distress and potential defaults.