At some stage, every Business needs funding for smooth operations. There are multiple funding sources available in the market for business organizations. Credit Facility offered by Banks is one such source. It can be understood as an agreement or arrangement between the borrower and banks where the borrower can borrow money for an extended period. Credit Facilities are utilized by the Companies, primarily to satiate the funding-needs for various business Operations. Banks on the other hand earn profit from the interest incurred on the principal amount lent to the borrower.
The different types of Credit Facilities can be broadly classified into two parts:
- Fund Based Credit
- Non-Fund Based Credit.
Let’s understand them in detail.
Fund Based Credit
Fund Based Credit is the one where the Bank provides the Fund directly to the Borrower without any third party involvement. It usually involves an immediate flow of funds to the borrower’s account. For e.g. Loans, Ods (Over Drafts), CCs (Cash Credit), PAD (Payment Against Documents), Consortium loans, etc.
Fund-Based Credit comes with multiple advantages. Let’s take a look at them.
- The fund-based Credit offers immediate funding to the borrower.
- The fund-based Credit offers actual funding for business operations.
The different types of fund based credits are as follows
1. Loan
A loan is a type of Fund-Based Credit where the Borrower has to repay the Credit within the pre-agreed time & interest. Loans are given to the business to meet their various running expenses such as production, distribution, expansion etc. A huge amount of loan can be given to the companies depending on their requirements. Although, to ensure the safety of returning of the funds, Credit Monitoring Arrangement Data reports are carefully monitored in funding cases that involve a large amount of principal.
Let’s take a look at different types of loans.
A) Demand Loans & Term Loans
Demand loan:
Demand Loans, sometimes known as working capital loans, are offered by the lender to the Borrower for the short-term.
As the name suggests, the Borrower has to repay the loan on the demand of the lender. There is no fixed tenure for the repayment. The Borrower can repay the loan in advance without paying any prepayment charges. These loans are generally offered against tangible assets or similar securities.
Term Loan:
These loans come with a predefined repayment schedule and tenure. As the tenure is fixed, the Borrower will have to pay some pre-payment charges in early payments. They are generally offered for the large funding requirements.
B) Unsecured Loan & Secured Loan
Unsecured Loan
These loans are offered to the Borrower without any collateral but generally carry a high interest rate. This means, if the Borrower defaults on the repayment of loan, there is no way for the lenders to acquire any asset of the Borrower whether it is tangible or non-tangible. These loans include Personal loans and student loans as well.
Secured Loan
The lenders offer these loans against any tangible or non-tangible asset like home, piece of land, vehicle etc. If the Borrower defaults on the payment, his/her assets can be acquired by the lender. Loans such as home loans and loans against property are a few types of secured loans.
2. Cash Credit
Cash credit is provided to the business owners to carry out their regular business expenses. In Cash credit, the borrower is given access to a current account from which they can withdraw money within a predefined limit for an agreed amount of time. The interest is charged on the daily closing balance of the account rather than the borrowing limit.
3. OverDraft
This Credit Facility is offered to Current Account holders in a particular bank, to borrow the fund more than their existing balance for a specific period. These credits are secured by the physical assets, pledge of FDs, Securities or Mortgage of some immovable property in some cases.
4. Credit Card
Under this facility, a Credit Cardholder can spend a fixed amount of money using the card offered to him/her by the Bank. The user has to pay the credits used within the stipulated time regularly. Any failure to pay the outstanding bills on time attracts a penalty from the Bank.
5. Export Finance
Export finance is the financing facility which is provided by the banks to fund exporters to meet their production and export needs. The different type of export finance are
A) Packing Credit Advances
These types of credits are offered to exporters to meet the expenses for manufacturing and packing the goods for export as per the buyer’s need. The credit is offered against hypothecation of goods stock, and any other assets of the Borrower.
B) Post Shipment Finance
These type of credits are offered to the exporters once they export their product to the buyers.These credits are offered to meet the interim cash requirement of the exporter. It is offered based on the document and invoices suggesting that the export is made.
6. Hire Purchase Finance
This type of finance is offered to the buyer when he/she is looking to buy some expensive product. Under this Credit, it is agreed that the buyer will pay some down payment initially and the rest of the amount will be paid in installments.
7. Bill Finance
In bill finance, a Bank draws a bill of exchange from another bank to transfer the funds due to Credit offered to the Borrower.
The different types of bill finance are
A) Bill Discounted
This Credit allows the seller to borrow money from Bank in advance against the payment that will be received by the seller in the future. The Bank deducts some charges as the fees from the payment, once the buyer deposits it
B) Bill Purchased
This Credit allows the seller to borrow funding based on a sales document not drawn under the Letter of Credit. The lending bank submits these documents to the buyer’s bank for the payments.
8. Leasing Finance
Under this credit facility, the owner of an asset gives the right to use that asset to the Borrower against the payment of a specific amount. It is one of the most important forms of medium and long-term finance. As the owner leases his/her property, he/she is known as the lessor, and the one who takes the property on lease is called the lessee.
9. Retail Credit
The banks offer Credit or loan to the Borrower to purchase certain moveable or immovable properties, durables, vehicles or similar products. This Credit is offered to the Borrower based on his/her credit history. This facility is offered on Business to Business transactions as well as Business to Customer transactions.
Non-Fund Based Credit
On the Contrary, Non-Fund Based Credit is where the Fund is not transferred directly to the borrower. It is offered to a third-party as agreed upon by the borrower, on behalf of the Borrower.
The bank usually acts as a guarantee provider to the seller on the behalf of the buyer. If the payment is not received by the seller within pre-agreed time, The bank pays the amount to the seller. For e.g. Bank Guarantee, Buyer Credit, Letter of Credit, Supplier Credit.
Following are the advantages of Non-Fund Based Credits:
- It offers financial security to the seller if the buyer defaults due to any reason.
- It offers Business expansion opportunities to the exporters.
The different types of non-fund based credit are
1. Letter Of Credit
A letter of credit is an assurance provided by the Bank to the seller on behalf of the buyer that the seller will receive the buyer’s payment at regular intervals. It also states that if the buyer fails to pay the seller for any reason, the Bank will be responsible for the remaining or full payment.
Letter of Credit is offered based on the collateral of cash or certain securities. With the rising international trading, Letter of Credit is becoming a crucial tool to manage the payments between parties that hardly know each other and live in different countries with different laws. The bank charges a certain percentage from the buyer as the fees for offering the Letter of Security.
The Letter of Credit can be divided into the following parts:
A) Sight Credit
This letter of Credit is quicker than others. Here the Borrower can take the lender’s funds by showing a bill of exchange and sight letter of Credit.
B) Revocable & Irrevocable Credit
Revocable Letter of Credits is the one that can be revoked or canceled by the issuing bank without prior notice to any party.
Irrevocable Letter of Credit cannot be revoked or canceled by the issuing Bank. So once the LOC is generated, Bank will have to honor the letter.
C) Confirmed Credit
In this type of Credit, a bank other than the issuing Bank confirms the Letter of Credit by adding its confirmation. Only Irrevocable Letter of Credit is eligible for confirmation.
D) Back-to-Back Credit
Under this type of Credit, the exporter requests the Bank to offer an LC to his/her local supplier. The request is based on the export LC received by the exporter from an overseas buyer. Here, an LC is issued based on an export LC and hence the name, Back-to-Back Credit.
The advantages of a letter of credit to the buyer is as follows
- Allows the buyer to trade with the parties from any corner of the world
- The buyer can edit the terms and conditions that fit him/her after consulting the seller.
- It acts as a credit certificate for the buyer, and he/she can perform multiple trades as a major financial institution like Bank backs him/her.
- Letter of Credit offers better Cash flow to the buyer.
The advantages Of a Letter Of Credit To seller is as follows
- The seller receives the money on fulfilling the terms mentioned In the Letter of Credit.
- There is no risk of losing money for the seller if the buyer fails to pay the money. Seller gets his/her dues from the Bank that has issued the Letter of Credit.
- The letter of Credit is easy to quick to avail based on good credit.
- If there is a dispute in trading, the seller can withdraw funds from the Bank even when the case is pending.
2. Bank Guarantee
Under this type of Credit, Bank offers assurance that under any circumstances, the Guarantee issuing Bank will fulfill any financial losses incurred by the protected party as mentioned in the Contract.
Let’s take a look at different guarantees
A) Financial Guarantee
In this type of Guarantee, the Guarantor takes responsibility for the Borrower. This means, if the Borrower fails to repay the debt, Guarantor will be liable to pay the unpaid amount.
B) Performance Guarantee
The Guarantor issued a security bond that assures the lender that the Contractor will complete the work satisfactorily in the stipulated time.
C) Deferred Payment Guarantee
This type of Guarantee is usually given on deferred or postponed payments. The banks generally offer DPG on the purchase of certain machinery and goods.
3. Letters Of Comfort For Availing Buyers Credit
Letter of Comfort can be understood as the Guarantee offered by the Bank of Importer or buyer. The Importer can use this Letter of Comfort to avail Buyer’s Credit from the Overseas banks. The Importer or Buyer’s Bank charges certain fees for offering the Letter of Comfort.
4. Derivative Products
Derivatives are a type of financial security or financial contracts that are backed by some underlying securities. These underlying securities can be anything, ranging from currencies, bonds, commodities to stocks.
5. Buyer Credit
It is a short-term funding option, offered to the Indian Buyers or Importers by the Bank to manage their import Business. Using Buyer’s Credit, the Importers can avail loans from foreign financial institutions which offer Credit at comparatively lower rates. Buyer’s Credit can be availed for importing almost all types of capital and non-capital goods.
6. Supplier Credit
This type of Credit is used to support the importers financially in India. Here any overseas Financial Institute or Supplier offers the Credit to the Importer on the Libor rates, which are comparatively low. Such Credit is backed by the Letter of Credit offered to the Importer via Importer’s Bank.
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