What is Cash Credit?
A Cash Credit (CC) is a short-term source of financing for a company. In other words, a cash credit is a short-term loan extended to a company by a bank. It allows a company to withdraw money from a bank account without keeping a credit balance but is only limited to borrow up to the borrowing limit. Also, the interest is charged on the amount borrowed and not the borrowing limit.
Important Features of Cash Credit
1. Borrowing limit
A cash credit comes with a borrowing limit determined by the drawing power of the borrower. A company can withdraw funds up to the borrowing limit.
2. Interest on running balance
In contrast with other traditional debt financing methods such as loans, the interest charged is only on the running balance of the cash credit account and not on the borrowing limit.
3. Minimum commitment charge
The short-term loan comes with a minimum charge from the loan amount regardless of whether the borrower is able to utilize it. For example, banks typically include a clause that requires the borrower to pay a minimum interest on a predetermined amount or the amount withdrawn, whichever is higher.
4. Collateral security
5. Credit period
It is typically given for a maximum period of 12 months, after which the drawing power is re-evaluated.
Example of Cash Credit
Company A is a phone manufacturer and operates a factory where the company invests money to purchase raw materials to convert them into finished goods. However, the products in finished goods inventory are not immediately sold – the company’s capital is stuck in the form of inventories. In addition to the capital getting stuck in inventories, the company must also meet its daily business expenses. In order for Company A to meet its expenses and wait for their finished goods inventory to convert into cash, the company takes a cash credit loan to successfully run their business without a shortfall.
Advantages of Cash Credit
1. Source of working capital financing
A cash credit is an important source of working capital financing as the company need worry about liquidity issues.
2. Easy arrangement
It can be easily arranged by a bank provided that collateral security is available to be pledged and the realizable value is easily determined.
Withdrawals on a cash credit can be made as many times up to the borrowing limit and deposits of excess cash into the account lowers the burden of interest that a company faces.
Interest payments made are tax-deductible and thus reduces the overall tax burden on the company.
5. Interest charged
A cash credit reduces the financing cost of the borrower as the interest charged is only on the utilized amount or minimum commitment charge.
Disadvantages of Cash Credit
1. High rate of interest
The interest rate charged by a loan on cash credit is very high.
2. Minimum commitment charges
A minimum commitment charge is imposed on the borrower regardless of whether the company utilizes its cash credit or not.
3. Difficulty in securing
The short-term loan is extended to the borrower depending on the borrower’s turnover, accounts receivable balance and expected performance, collateral security offered, etc. Therefore, it can be difficult for new companies to obtain.
4. Temporary source of finance
The loan is a short-term source of financing and thus a company cannot rely on it for an extended period of time. After the expiration of a cash credit loan, it must be renewed under new terms and conditions.
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