Cash Credit - Definition, Features, Examples, Advantages and Disadvantages

Features of cash credit

• Revolving credit: Cash credit provides a revolving line of credit that allows businesses to borrow up to a predetermined limit
• Flexible repayment: Borrowers can repay and redraw funds as needed, making it suitable for managing fluctuating cash flow.
• Interest charges: Interest is charged only on the amount borrowed and for the duration of its use, offering cost-effective financing.
• Collateral requirement: Cash credit often requires collateral, such as inventory, accounts receivable, or property, to secure the line of credit.
• Monitoring: Lenders may monitor the borrower's financial performance and require periodic reviews to assess creditworthiness and adjust credit limits accordingly.

Factors of Cash Credit

Several factors help decide how much a borrower can get through a loan:

• The borrower’s past repayment history
• The amount of money the borrower wants to borrow
• The borrower’s ability to repay the loan
• The business’s current assets and liabilities
• The security or collateral offered for the cash credit facility
• The borrower’s overall credit profile

How Does Cash Credit Work?

A cash credit facility is a type of short-term loan. Therefore, according to accounting rules and standards, it should be shown on the liabilities side of the balance sheet under the heading "Short Term Loans."

Let’s take an example.
Company A is a mobile phone manufacturer. It runs a factory where it spends money on buying raw materials and converting them into finished products. However, these finished goods are not sold immediately, so the company’s money gets stuck in stock.

To manage its day-to-day expenses while waiting for the stock to be sold and turned into cash, Company A takes a cash credit loan. This helps the company continue its operations smoothly without running into a shortage of working funds.

Eligible to Avail Cash Credit Facility

The following can get a cash credit facility:

• People
• Self-employed/Professionals
• Partnership businesses
• Limited liability partnerships (LLPs)
• Registered trusts
• Private companies
• Public companies
• Co-operatives

Required documents for cash credit facility

To use this service, you’ll need to submit your KYC documents along with a few other papers that help show the nature and stability of your business. Below is the list of required documents:

• PAN Card
• Applicant’s Identity Proof
• Applicant’s Address Proof
• Recent Passport-Sized Photographs
• Bank Statements
• Filled Application Form
• Financial Statements (like balance sheet and profit & loss account)
• Income Tax Returns (ITR) and GST Returns
• Proof that your business is active (like invoices or trade licences)
• Business Address Proof
• Partnership Deed or Memorandum of Association and Articles of Association (if applicable)
• Details of any collateral or security being offered
• Information about existing loans or liabilities
• GST Registration Certificate(s)

Example of a cash credit

A company makes mobile phones and runs a factory where it spends money to buy raw materials and turn them into finished products. But these finished products don’t sell immediately. So, the company’s money is stuck in the form of unsold stock. To manage its daily expenses while waiting to sell this stock and get cash, a company takes a cash credit loan. This helps the company keep running smoothly without facing a cash shortage.

Advantages of cash credit

• Flexibility: Cash credit offers businesses flexibility in borrowing and repaying funds as needed, allowing them to manage cash flow fluctuations effectively.
• Cost-effectiveness: Interest is charged only on the amount borrowed and for the duration of its use, making cash credit a cost-effective financing option.
• Working capital management: Cash credit helps businesses maintain adequate working capital levels to cover operational expenses and seize growth opportunities.
• Collateral utilization: Businesses can use assets such as inventory, accounts receivable, or property as collateral, unlocking their value to secure the line of credit.
• Continuous access: With cash credit, businesses have continuous access to funds, enabling them to address short-term financing needs promptly.

Disadvantages of cash credit

• Interest costs: Cash credit can incur higher interest costs compared to term loans, especially if the borrowed funds are not repaid promptly.
• Collateral requirement: Lenders often require collateral to secure cash credit, which may tie up valuable assets and restrict their use for other purposes.
• Potential for overborrowing: The revolving nature of cash credit can lead to overborrowing if businesses are not careful, resulting in excessive debt and financial strain.
• Monitoring and review: Lenders may impose regular reviews and monitoring of the borrower's financial performance, adding administrative burden and potential restrictions on credit usage.
• Dependency: Businesses may become overly reliant on cash credit, leading to a lack of diversification in financing sources and increased vulnerability to economic downturns or changes in credit conditions.

Limitations of Cash Credit

Collateral requirement: Cash credit is not suitable for businesses that cannot offer assets as security.

Strict evaluation: To get cash credit, you need to provide detailed financial statements and have a good credit history.

Commitment charges: Some banks may charge fees for opening and maintaining the loan account.

Short tenure: The repayment period is usually within 12 months, so cash credit is not ideal for long-term funding needs.

Principal elements of cash credit

• Credit limit: The maximum amount that can be borrowed under the cash credit facility.
• Interest rate: The rate charged on the borrowed funds, typically based on the prevailing market rates and the borrower's creditworthiness.
• Collateral: Assets pledged to secure the cash credit facility, assuring the lender against default.
• Repayment terms: The terms governing the repayment of borrowed funds, including interest payments and the timeline for repayment.
• Revolving nature: Cash credit offers a revolving line of credit, allowing borrowers to borrow, repay, and redraw funds as needed within the credit limit.
• Monitoring: Lenders may monitor the borrower's financial performance and conduct periodic reviews to assess creditworthiness and adjust credit limits accordingly.

Cash credit vs overdraft

Usually, cash credit and overdraft are considered similar financial products as most of their features overlap. However, there are some points on which these products can be differentiated, as discussed below:

How to avail cash credit?

Here are a few simple steps to secure cash credit:

1. Research and select a financial institution:Explore financial institutions offering cash credit facilities with favourable terms. Assess interest rates, collateral requirements, and credit limits for comparison.
2. Ensure eligibility:Meet bank requirements such as creditworthiness and financial stability. Confirm availability of necessary documentation like identification and income statements.
3. Complete application:Visit the financial institution to request a cash credit application form or start your application online. Fill out the form accurately and submit it along with required documents.
4. Credit assessment and negotiation:The financial institution evaluates your creditworthiness and assesses collateral value. Negotiate terms including credit limit, interest rates, and repayment schedule.
5. Activation and utilisation:Upon approval, the financial institution activates your cash credit facility. Utilise the available credit responsibly for short-term financial needs, ensuring compliance with agreed terms and conditions.

Managing your cash credit facility

Managing your cash credit facility efficiently is crucial for financial stability and growth. Here's how to do it effectively:

1. Strategic utilisation: Use the credit judiciously for short-term needs like inventory restocking or operational expenses to optimise its benefits.
2. Clear repayment plan: Develop a concise repayment strategy to pay off the outstanding balance on time, minimising interest costs and maintaining a healthy credit profile.
3. Regular monitoring: Keep a close eye on your credit utilisation to avoid exceeding the approved limit and incurring unnecessary interest charges.
4. Understanding terms: Familiarise yourself with the terms and conditions of your cash credit facility to ensure compliance with repayment schedules, interest rates, and other obligations.
5. Communication: Maintain open communication with your financial services provider regarding any changes in your financial situation or challenges in meeting repayment obligations, ensuring a mutually beneficial relationship.

How does cash credit help businesses?

Cash credit can help your business with the following:

• Buying raw materials: As a business owner, you need enough raw materials for smooth operations. Cash credit gives you the money to buy raw materials on time.
• Maintaining stock: Your inventory is crucial for your business. With cash credit, you can ensure you have the money to keep your inventory fully stocked to serve your customers.
• Paying wages and rent: Running a business means covering costs like staff wages and rent. You can use cash credit for any purpose, including meeting these essential business expenses.
• Boosting sales: Your goods and services need a good strategy to sell. You can use cash credit to fund a marketing and sales team to promote your business.

Conclusion

In conclusion, cash credit is an important financial tool for businesses in India, especially those needing quick access to working capital. Whether it’s for buying raw materials, managing stock, paying wages, or boosting sales, cash credit helps businesses operate smoothly without facing cash flow problems.

With flexible usage, interest charged only on the amount you actually use, and easy availability through many banks and NBFCs, it is a practical option for daily business needs.

For other financial needs, you might also consider a business loan, where you can check the business loan interest rate and calculate your payments using the business loan EMI calculator.

However, it’s important to use cash credit responsibly and plan well to avoid over-reliance and keep costs under control.