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A business needs access to a regular source of funds to function well. From paying wages and salaries to the employees to taking care of supply chain issues, any business will require credit irrespective of its scale of operations. Neglecting these working capital requirements could lead to potential trouble for the firm. Cash credit loans focus on bridging the gap between working capital requirements and the availability of funds.
Financial institutions extend it as a short-term loan to businesses. In this article, we will understand how cash credit loans work, why they are popular and should a firm opt for it or not?
In the case of cash credit loans, the borrowing limit gets determined according to the borrower’s creditworthiness. Governed by their current assets and liabilities, the lender may use raw materials, finished goods and stock-in-trade as collateral. The firm can withdraw funds up to the amount of this calculated borrowing limit.
Unlike conventional sources of finance, for cash credit loans, interest is charged only on the amount withdrawn and not the total borrowing limit of the firm.
Businesses opting for a cash credit loan also incur a commitment charge even if it does not withdraw any amount. These charges vary from lender to lender.
As we mentioned earlier, a company can get these loans for a maximum period of one year. Once the loan tenure is over, and the outstanding dues are repaid — drawing limits are recalculated.
An entrepreneur or business can easily arrange funds through a cash credit loan. Provided the collateral is available to the lending institution and its value easily determined — these loans are the best way to arrange funds quickly.
Since these advances allow a firm to withdraw cash within the borrowing limit, the firm can make withdrawals multiple times. It gives the added benefit of flexibility to the business.
These loans only levy interest on the amount withdrawn. That brings down the cost of financing for the borrowing firm
Cash credit loans work out to be an excellent source of working capital for a firm in need of credit. The business does not have to worry about liquidity and can pledge its current assets in favour of obtaining funds.
As compared to traditional sources of credit, cash credit loans have higher interest rates. While you can bring down the interest rate by increasing the value of collateral, it still works out to be a more expensive source of finance.
Irrespective of whether the business utilises its cash credit limit or not — a minimum commitment charge is levied, further increasing the cost of financing
Companies cannot rely on these loans for a long time due to the inherent nature of these loans. If the firm wishes to continue with its cash credit once the one year period is over, the limit will be recalculated, which may not always suit the firm.
Cash credit is recorded in current liabilities under the subhead “Short Term Loans” on the balance sheet. The bank that provides the cash credit facility establishes a current account in the firm’s name. Journal and ledger entries take place in the same way that transactions in other bank accounts are done. A cash credit account will always reflect a credit balance, whereas a regular bank account will always reflect a debit balance.
Cash credit is a type of business loan extended for a short period. Businesses looking for immediate working capital financing use these loans. An overdraft facility, on the other hand, is a type of long-term financial aid. It allows users to withdraw funds from their accounts even if there is no balance.
Cash credit loans fulfil business requirements, while overdrafts help in taking care of non-business needs. Besides that, the interest incurred on overdrafts is usually higher than that of cash credit loans. Lastly, the credit limit for these is fixed and is determined according to the firm’s current assets, while in the case of overdrafts, there is some leeway in terms of limit depending upon the borrower’s relationship with the institution.
For a business in dire need of working capital finances, a cash credit loan may seem like the most viable course of action. However, loans always come at a price, and in the case of cash credit loans, the price is often higher. Therefore, it is vital to make sure that you understand how it works before opting for it.
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