Concept 1 · free preview
Types of bank credit: term loan, cash credit, overdraft, bills, LC and BG
Understand
Banks lend in two broad ways. In fund-based credit the bank actually pays out money — the borrower's account is debited. In non-fund-based credit the bank only gives a promise (a letter of credit or a bank guarantee); no money leaves the bank unless the promise is called upon, so it is a contingent liability of the bank. A term loan is repayable after a specified term, usually in instalments — for buying machinery, a house or a car. A demand loan is repayable whenever the bank demands it. Working capital — money to buy raw material, hold stock and wait for buyers to pay — is usually given as a cash credit or overdraft. Cash credit (CC): the bank sanctions a limit against the borrower's stock and receivables, which are hypothecated or pledged to the bank. The borrower can draw up to the drawing power (value of eligible stock and receivables minus the margin) or the limit, whichever is lower, and pays interest only on the amount actually used. Overdraft (OD): permission to withdraw more than the balance in a current account, often against fixed deposits, shares or salary. Bill finance: a seller who has sold goods on credit holds a bill of exchange on the buyer. The bank purchases a demand bill or discounts a usance (time) bill, paying the seller now and collecting from the buyer later. RBI allows this only for genuine trade transactions — banks may not purchase or discount accommodation bills. Letter of credit (LC): the buyer's bank undertakes to pay the seller when the seller presents documents as per the LC. Bank guarantee (BG): the bank promises to pay the beneficiary if its customer fails to pay (financial guarantee) or fails to perform a contract (performance guarantee). When an LC devolves or a BG is invoked, it becomes a fund-based exposure.
Rule
Fund-based: term loan, demand loan, cash credit, overdraft, bills purchased/discounted.
Non-fund-based: letter of credit and bank guarantee — contingent liabilities of the bank.
Term loan = repayable after a specified term period (RBI definition); demand loan = repayable on demand.
Drawing power = (eligible stock + receivables) − margin; withdrawal allowed up to the lower of drawing power and sanctioned limit.
Demand bills are purchased; usance bills are discounted. No purchase/discount of accommodation bills.
LC parties: applicant (buyer), issuing bank, beneficiary (seller), advising/negotiating bank.
In a CC/OD, no pre-payment charge applies if the borrower tells the bank in time that the facility will not be renewed and it closes on the due date.
Example
Ramesh Textiles has a cash credit limit of ₹40 lakh. Its stock and receivables are worth ₹50 lakh and the margin is 25%, so drawing power = 50 − 12.5 = ₹37.5 lakh. It can draw only ₹37.5 lakh (lower of ₹37.5 lakh and ₹40 lakh) and pays interest only on what it uses. For importing a dyeing machine from Germany, its bank opens an LC; the bank pays the German exporter on receiving shipping documents, and only then does the LC turn into a fund-based exposure.
| Point | Cash credit | Overdraft | Term loan |
|---|---|---|---|
| Purpose | Working capital | Short-term needs | Fixed assets / long-term needs |
| Basis | Drawing power on stock and receivables | Current account; FD/shares/salary | Project or asset cost |
| Repayment | Running account, renewed periodically | Running account | Fixed instalments over the term |
| Interest | On amount used | On amount used | On outstanding balance |
Common mistake
A bank guarantee or LC is NOT a loan when issued — it is non-fund-based; it becomes fund-based only on invocation/devolvement.
In a CC the borrower cannot draw the full sanctioned limit if drawing power is lower.
Usance bills are 'discounted'; demand (sight) bills are 'purchased'.
Accommodation bills (no real trade behind them) cannot be discounted by banks.