CASH CREDIT :
Cash credit is the main method of lending by banks in India and accounts for about 70 per cent of total bank credit. Under the system, the banker specifies a limit, called the cash credit limit, for each customer, up to which the customer is permitted to borrow against the security of tangible assets or guarantees. Cash credit is a flexible system of lending under which the borrower has the option to withdraw the funds as and when required and to the extent of his needs. Under this arrangement the banker specifies a limit of loan for the customer (known as cash credit limit) up to which the customer is allowed to draw. The cash credit limit is based on the borrower’s need and as agreed with the bank. Against the limit of cash credit, the borrower is permitted to withdraw as and when he needs money subject to the limit sanctioned. It is normally sanctioned for a period of one year and secured by the security of some tangible assets or personal guarantee. If the account is running satisfactorily, the limit of cash credit may be renewed by the bank at the end of year. The interest is calculated and charged to the customer’s account. Cash credit, is one of the types of bank lending against security by way of pledge or /hypothecation of goods. ‘Pledge’ means bailment of goods as security for payment of debt. Its primary purpose is to put the goods pledged in the possession of the lender. It ensures recovery of loan in case of failure of the borrower to repay the borrowed amount. In ‘Hypothecation’, goods remain in the possession of the borrower, who binds himself under the agreement to give possession of goods to the banker whenever the banker requires him to do so. So hypothecation is a device to create a charge over the asset under circumstances in which transfer of possession is either inconvenient or impracticable.
Other features of cash credit arrangements are as follows:
(1) The banker fixes the cash credit limit after taking into account several features of working of the borrowing concern such as production, sales, inventory levels, past utilization of such limits; etc. The banks are thus inclined to relate the limits to the security offered by their customers.
(2) The advances sanctioned under the cash credit arrangement are technically repayable on demand and there is no specific date of repayment, but in practice they ‘roll over’ a period of time. Cash accruals arising from the sales are adjusted in a cash credit account from time to time but it is found that on a larger number of accounts no credit balance emerges or debit balance fully wiped out over a period of years as the withdrawals are in excess of receipts.
(3) Under the cash credit arrangement, a banker keeps adequate cash balances so as to meet the demand of his customers as and when it arises. But the customer is charged interest only on the actual amount utilized by him. To neutralize the loss of interest on the idle funds kept by the banks within the credit limits sanctioned, a commitment charge on the unutilized limits may be charged by the banks.
(4) The Reserve Bank has advised the banks to evolve their own guidelines to ensure credit discipline and levy a commitment charge. Thus the commitment charge depends upon the discretion of individual banks. Advantages of Cash Credit System
1. Flexibility: The borrowers need not keep their surplus funds idle with themselves, they can recycle the funds quite efficiently and can minimize interest charges by depositing all cash accruals in the bank account and thus ensures lesser cost of funds to the borrowers and better turnover of funds for the banks.
2. Operative convenience: Banks have to maintain one account for all the transactions of a customer. The repetitive documentation can be avoided. Weakness of the System
1. Fixation of Credit Limits: The cash limits are prescribed once in a year. Hence it gives rise to the practice of fixing large limits than is required for most part of the year. The borrowers misutilise the unutilized gap in times of credit restraint.
2. Bank’s inability to verify the end-use of funds: Under this system the stress is on security aspect. Hence there is no conscious effort on the part of banks to verify the end-use of funds. Funds are diverted, without banker’s knowledge, to unapproved purposes.
3. Lack of proper management of funds: Under this system the level of advances in a bank is determined not by how much the banker can lend at a particular time but by the borrower’s decision to borrow at the time. The system, therefore, does not encourage proper management of funds by banks.
These weaknesses of the cash credit system were highlighted by a number of committees appointed for this purpose in India. Guidelines have been issued by the Reserve Bank for reforming the cash credit system on the basis of recommendations of the Tandon Committee and the Chore Committee.
Overdrafts
When a customer is maintaining a current account, a facility is allowed by the bank to draw more than the credit balance in the account; such facility is called an ‘overdraft’ facility. At the request and requirement of customers temporary overdrafts are also allowed. However, against certain securities, regular overdraft limits are sanctioned.
Salient features of this type of account are as under:
(i) All rules applicable to current account are applicable to overdraft accounts mutatis mutandis.
(ii) Overdraft is a running account and hence debits and credits are freely allowed.
(iii) Interest is applied on daily product basis and debited to the account on monthly basis. In case of temporary overdraft, interest should be applied as and when temporary overdraft is adjusted or at the end of the month, whichever is earlier.
(iv) Overdrafts are generally granted against the security of government securities, shares & debentures, National Savings Certificates, LIC policies and bank’s own deposits etc. and also on unsecured basis.
(v) When a current account holder is permitted by the banker to draw more than what stands to his credit, such an advance is called an overdraft. The banker may take some collateral security or may grant such advance on the personal security of the borrower. The customer is permitted to withdraw the amount as and when he needs it and to repay it by means of deposit in his account as and when it is feasible for him. Interest is charged on the exact amount overdrawn by the customer and for the period of its actual utilization.
(vi) Generally an overdraft facility is given by a bank on the basis of a written application and a promissory note signed by the customer. In such cases an express contract comes into existence. In some cases, in the absence of an express contract to grant overdraft, such an agreement can be inferred from the course of business. For example, if an account-holder, even without any express grant of an overdraft facility, overdraws on his account and his cheque is duly honoured by the bank, the transaction amounts to a loan. In Bank of Maharashtra v. M/s. United Construction Co. and Others (AIR 1985 Bombay 432), the High Court concluded that there was an implied agreement for grant of overdraft or loan facility.
(vii) Banks should, therefore, obtain a letter and a promissory note incorporating the terms and conditions of the facility including the rate of interest chargeable in respect of the overdraft facility. This is to be complied with even when the overdraft facility might be temporary in nature.
Overdraft facility is more or less similar to ‘cash credit’ facility. Overdraft facility is the result of an agreement with the bank by which a current account holder is allowed to draw over and above the credit balance in his/her account. It is a short-period facility. This facility is made available to current account holders who operate their account through cheques. The customer is permitted to withdraw the amount of overdraft allowed as and when he/she needs it and to repay it through deposits in the account as and when it is convenient to him/her.
Overdraft facility is generally granted by a bank on the basis of a written request by the customer. Sometimes the bank also insists on either a promissory note from the borrower or personal security of the borrower to ensure safety of amount withdrawn by the customer. The interest rate on overdraft is higher than is charged on loan.
Bills Finance
In order to ease the pressures on cash flow and facilitate smooth running of business, Bank provides Bill finance facility to its corporate / non corporate clients. Bill finance facility plugs in the mismatches in the cash flow and relieves the corporates from worries on commitments. Besides the fund based bill finance, we also provide agency services for collection of documentary bills/cheques. Under bills finance mechanism a seller of goods draws a bill of exchange (draft) on buyer (drawee), as per payment terms for the goods supplied. Such bills can be routed through the banker of the seller to the banker of the buyer for effective control.
(i) Clean & Documentary bill :
(a) When documents to title to goods are not enclosed with the bill, such a bill is called Clean Bill. When documents to title to goods along with other documents are attached to the bill, such a bill is called ‘Documentary Bill’.
(b) Documents, the due possession of which give title to the goods covered by them such as RR/MTR, bill of lading, delivery orders etc. are called documents to title to goods.
(c) Cheques and drafts are also examples of clean bills.
(ii) Demand & Usance bill :
When the bill of exchange either clean or documentary is made payable on demand or sight, such a bill is called Demand Bill. The buyer is expected to pay the amount of such bill immediately at sight. If such a demand bill is a documentary bill, then the documents including document to title to goods are delivered to the buyer only against payment of the bill. (Documents against Payment-D/P Bills).
When a bill, either clean or documentary is drawn payable after certain period or on a specified date, the bill is called Usance Bill. Such bill is presented to the buyer once for Acceptance, when he accepts to pay the bill on due date and on due date the bill is presented again for Payment. In case of documentary usance bill, the documents are delivered to the buyer (drawee/acceptor) against his acceptance of bill (Documents against acceptance – DA Bills).
Finance against bills of exchange: Difference between Bills Purchase and Bills Discounting Banks consider working capital finance to meet the post- sale requirements of borrowers through Bill finance either by ‘Purchasing’ bills or ‘Discounting’ them.
(a) Bill Purchase facility is extended against clean demand bills like cheques / drafts/ bills of exchange/ hundies & demand documentary bills, whereby the bank lends money to the payee of the cheque/ draft and to the drawer of the bills by purchasing the same against tendering of such bills by the payee/ drawer.
The bank in turn sends the bills for collection, preferably to its own branch at the place of drawee or to its correspondent bank or to the buyers (drawee’s) bank.
(b) Bills Discounting facility is extended against usance bills: In such cases, the seller tenders the usance bill drawn by him usually along with documents to title to goods, to his banker who discounts the bill i.e. levies discount charges for the unexpired portion of the duration of the bill and credits the balance amount to the seller’s account. Thereafter the drawer’s bank sends the bill to collecting bank at the centre of drawee either to its own branch or drawee’s bank, with instructions to release the documents to title against acceptance and thereafter, to recover the bill amount on due date. Sometimes the accepted usance bills are also tendered and discounted by the bank.
Apart from sanctioning loans and advances, discounting of bills of exchange by bank is another way of making funds available to the customers. Bills of exchange are negotiable instruments which enable debtors to discharge their obligations to the creditors. Such Bills of exchange arise out of commercial transactions both in inland trade and foreign trade. When the seller of goods has to realize his dues from the buyer at a distant place immediately or after the lapse of the agreed period of time, the bill of exchange facilitates this task with the help of the banking institution. Banks invest a good percentage of their funds in discounting bills of exchange. These bills may be payable on demand or after a stated period.
In discounting a bill, the bank pays the amount to the customer in advance, i.e. before the due date. For this purpose, the bank charges discount on the bill at a specified rate. The bill so discounted , is retained by the bank till its due date and is presented to the drawee on the date of maturity. In case the bill is dishonoured on due date the amount due on bill together with interest and other charges is debited by the bank to the customers
Procedure for Assessment of Working Capital
The term “Working Capital” means, the funds required by a company, enterprise to carry on with daily operations. The features of Working Capital (WC) are:
(a) WC is the short term funds required to meet the daily operating expenses.
(b) WC = Current Assets – Current Liabilities.
(c) Managing the short term fund requirements through the firm’s short term assets and short liabilities is known as “Working Capital Management”.
(d) One of the main objective of Working Capital Management is to convert Cash to Cash (C to C) in a cyclical form called as “working capital cycle”.
Working Capital Cycle
The Working Capital Cycle operates in the following manner:
1. A borrowing company, avails of working capital finance from the bank. The bank after necessary credit appraisal , grants the working capital finance. The company withdraws funds (cash). The borrower converts the cash into raw material, raw material is used in the manufacturing activities, and gets converted into semi- finished and finished goods depending upon the production schedule. The finished goods are sold invariably on credit sales basis. Bills of exchange are drawn by the seller of the goods on the buyer, which becomes the bills receivable for the seller. On the due date when the bills are paid by the drawee (buyer), the seller repays the working capital loan amount to the bank.
2. The Working Capital Cycle covers two important financing functions viz., Inventory financing and receivables financing. The items consisting of cash- raw materials- semi finished goods-finished goods is called as Inventory, and the other items of the cycle, consisting of Bills receivables is called Receivables. In view of the above, it can be recognized that the Working Capital Management is the management of Inventory and Receivables. Efficient management of both inventory and receivables enables the firm to ensure that (Cash to Cash) if properly handled could result in effective cost management and increase in profitability for the firm.
3. Generally, the length of the working capital cycle depends upon:
(i) the stocks of raw material to be held
(ii) the period of time for converting the raw materials to semi-finished and finished goods
(iii) the credit period extended to the purchasers (debtors). The longer the working capital cycle, the funds requirement of the firm would be more
Broadly, working capital is classified into:
Gross Working Capital and Net Working Capital
Gross Working Capital:
The total current assets are referred as the gross working capital. It is also known as the qualitative or circulating capital.
Current Assets:
(i) Short term Assets (maturing within a year) which are used in the ordinary course of business (ii) Such assets can be converted into cash within a particular period (maximum period is one year)
Current Liabilities:
(i) Short term Liabilities (maturing within a year) which are used in the ordinary course of business (ii) Such liabilities are payable within a particular period (maximum period is one year) (iii) Usually the payment of current liabilities are made out of the current assets or revenue of the firm.
Net Working Capital:
It represents the excess of current assets over the current liabilities.
Banks should be able to assess the adequate working capital required by the firm/company. Because excess working capital means that the firm is having idle funds, which does not earn profit for the firm. It also blocks the bank’s funds which could have been lent to another needy borrowing company/firm. However, if the working capital is inadequate, it indicates that the firm is not having sufficient funds for its operations, which can result in lower production
Permanent and Temporary Working Capital:
Permanent working capital is the minimum investment kept in the form of inventory of raw materials, work-inprogress, finished goods, and book debts to ensure continuous operation of a firm.
Temporary Working Capital:
When a firm maintains additional current asset over and above the permanent working capital to cover the cyclical (seasonal) demands, it is called temporary working capital.
For example, a garment exporter may require additional funds to meet his exports to US and European markets for their festival season (Christmas, New Year). He approaches his bank for additional WC, and if the bank allows the exporter to avail of additional funds, then it is called temporary or seasonal WC
Working Capital – Bank Finance:
Banks grant working capital finance to their clients based on certain norms. The steps involved are Level of Turnover of the firm: This is one of the important step involved in deciding the working capital limit. In respect of existing firms, the past performance is used for deciding the limit. However, in case of new firms, the assessment is based on the availability of raw materials, production capacity, industry norm, etc., are taken into consideration to fix the working capital limit.
Banks are now free to decide the method of calculating the working capital requirements based on the bank’s own policy, generally banks use any of the following methods:
Method I:
In this method, the firm is required to contribute at least 25% of the working capital gap. The working capital gap = total current assets minus total current liabilities excluding bank finance.
Method II:
In this method, the firm has to bring in at least 25% of the total current assets.
Method III:
In this method, the firm is required to bring in 100% of those current assets called as “core assets” and at least 25% of the remaining current assets.
In the case of Method II, the current ratio should be at least 1.33 and in the first case, it could be less and in the third method it may be more.
Working capital management calls for skills good planning and strategy. A good working capital management would depend upon many factors, such as,
(i) Size of business (ii) Seasonal demand for funds (iii) Production Cycle Process (iv) Availability or non- availability of raw materials (v) inventory and receivables management policies (vi) Turnover of inventory (vii) Efficient receivable management
Working Capital finance is granted by banks in the form of cash credit (CC) and overdraft (OD). Cash Credit is given against hypothecation/ pledge of stocks/ movable assets for various purposes. While granting cash credit limit, the bank requires the borrower to contribute the margin say 25% of the value of assets (pledged/hypothecated). Bank allows the customer to drawdown subject to margin which is called the drawing power. If the limit is ‘100 lakhs and with the margin of 25% the drawing power subject to the security (stock/value of assets pledged/ hypothecated) would by ‘ 75 lakhs or less. In case of OD accounts also the drawdown of funds would be subject to margin and drawing power of the borrower. Banks should follow all the required guidelines of closely monitoring the operations in the CC accounts. Banks should also take necessary precautions in ensuring regular inspections of stocks and also the value of stocks are regularly valued at market price (mark to market concept) to avoid any risks. Banks stocks and assets should have insurance cover and all terms and conditions of the credit needs to be complied with.
Invariably, CC is given against movable goods/assets, and the OD is given against financial securities like bills of exchange, fixed deposit receipts, shares and tradable market instruments, and book debts. In the case of OD also, all applicable credit norms needs to be observed by banks without any deviation. Based on the nature of securities, they are either hypothecated, pledged, assigned, to banks or kept under lien with banks.