Companies finance their operations through different sources. A company must first identify its needs for financing. Once it does so, it must choose the best finance source to fund its operations. One of the most crucial factors among these includes the duration. Usually, equity finance is long-term, while debt finance can be both long- and short-term.
One of the types of short-term debt finance includes cash credit.
What is Cash Credit?
Cash credit refers to a type of short-term debt facility. It allows borrowers to withdraw money from their current account even when they don't have a credit balance. However, it comes with a borrowing limit based on various factors. On top of that, it also requires creating a new loan account. Cash credit allows account holders to make payments despite having no balance in their accounts.
Cash credit is often available to companies, businesses, and other organizations. It allows these entities to fund their short-term working capital needs. Therefore, they are also known as working capital loans. Although cash credit sounds similar to an overdraft facility, they are different. Cash credit facilities also require a prior agreement between the lender and borrower.
How does Cash Credit work?
Cash credit is a form of a line of credit facility available on current accounts. It allows the account holder to withdraw cash or make payments without having any balance on those accounts. However, these come with a borrowing limit preapproved by the borrower. This limit varies based on the conditions and differs from one lender to another. Once the borrower receives this facility, they can use it at any time.
When borrowers avail of cash credit, they must pay a daily interest charged on the closing balance. Therefore, they do not get charged for the preapproved borrowing limit. Usually, the interest rate on cash credit facilities is higher than on long-term loans. However, they may be lower compared to overdrafts and other debt facilities.
What is the difference between Cash Credit and Overdraft?
Cash credit and overdraft function similarly. However, they differ in various critical aspects. Usually, a cash credit facility comes with a lower interest rate for the account holder. One of its primary characteristics is that this facility requires the hypothecation of stocks and inventory. Therefore, it is a secured debt facility. On the other hand, an overdraft is usually unsecured and comes with a higher interest rate.
The borrowing limit on the cash credit facility depends on the volume of stocks and inventory hypothecated. On the other hand, overdraft limits depend on financial credit history and other factors. As stated above, cash credit requires the borrower to create a new account. However, an overdraft facility is available on existing accounts.
What are the advantages and disadvantages of Cash Credit?
A cash credit facility comes with the following advantages.
- More flexible compared to other types of debt finance.
- Provides a decent option to fund working capital needs.
- More favourable interest terms.
However, it may also have the following disadvantages.
- Higher interest rates compared to long-term debt.
- Only provides a temporary solution to financing needs.
- May be difficult to obtain for startups and smaller companies.
Conclusion
Cash credit is a short-term debt facility used by companies to finance their working capital needs. It allows them to make payments even when they don't have the remaining balance in their current accounts. However, it comes with a borrowing limit preapproved by the borrower. Despite its similar features, cash credit differs from overdraft facilities.
Article Source Here: Cash Credit: Meaning, Definition, Accounting, vs Overdraft
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