Lenders sanction borrowing limit of cash credit facility on the basis of credit worthiness of the accountholder.
Credit is often considered as crucial lifeline for most businesses. With both purchases and sales of inventories being made on credit, a mismatch in receivables and payables of business can strain a firm’s working capital, putting its daily operations in jeopardy. Such shortfalls have to be either met through increase in the capital or seeking credit from banks or relatives. Here we will focus on one of the most popular sources of working capital finance.
Lenders sanction borrowing limit of cash credit facility on the basis of credit worthiness of the accountholder. Apart from his credit score, lenders analyse financial statements, six months bank statements and collateral offered to judge his creditworthiness. Once sanctioned, borrower can withdraw up to the sanctioned limit and make repayments whenever he has sufficient liquidity to repay the overdrawn money.
Borrower can overdraw from his cash credit account up to the sanctioned limit as many times as he requires. He can make as many numbers of deposits, in part or in full, as per his liquidity. This makes cash credit an important tool of working capital financing as the borrower can always look forward to his cash credit account for funding short-term shortfalls.
Interest on cash credit facility is not calculated on the sanctioned limit but on the amount overdrawn for the period, until its repayment. This helps in reducing financing cost of the business as the accountholder can repay the overdrawn amount whenever he has excess liquidity. However, the interest rates are higher than other business loans.
As the pre-determined credit limit is a commitment to lend from the bank to its borrower, it has to set aside the funds for the sanctioned limit. However, the bank earns interest only on the amount overdrawn and not on the entire credit limit. Hence, banks charge commitment fee to compensate themselves for the opportunity cost of missing interest income from the unused sanctioned limit. This fee can go up to 1% of the unused sanctioned limit based on the ulitilisation of the sanctioned limit. Thus, businesses should carefully study their funding cycle while applying for a cash credit facility as an unnecessary larger credit limit would increase the cost of financing.
Banks ask for collaterals while sanctioning borrowing limits in cash credit account. These collaterals are usually in the form of stocks-in-trade and account receivables. Banks may also ask for additional security in the form of mortgage of immovable property and liquid assets. While cash credit facility certainly helps established businesses to monetise their account receivables or stocks-in-trade in the form of collateral security, new or weaker businesses find it difficult to avail cash credit facility due to their inability to furnish sufficient collaterals.
Cash credit facility is usually offered for a period of 12 months, after which the bank re-evaluates the creditworthiness of the account holder and accordingly sanctions fresh drawing power. The accountholder has to repay the over-drawn amount before the expiry of the repayment period. Thus, short tenure and revaluation of drawing power at regular intervals make cash credit a short-term source of financing. Hence, borrowers should not use cash credit facility to finance capital expenditures, as such expenditures usually take longer time to generate profit.
The writer is head, Business Loan, Paisabazaar.com