Cash credit is a short-term financing source for businesses. It works similarly to an overdraft bank facility. It is an important financing source for businesses in managing their working capital requirements.
Unlike an overdraft, a cash credit facility requires collateral. The interest charges apply to the portion of credit utilized only.
Contrary to a traditional bank loan, the bank does not charge interest on fixed terms or the full borrowing limit. The cash credit limit approval works similarly to that of a secured loan.
Important Features of a Cash Credit Facility
The cash credit facility is usually awarded to corporate account holders. The working mechanism of cash credit works similarly to that of an overdraft facility.
Approval of Cash Credit
Banks appraise the cash credit application based on the creditworthiness of the borrower. Credit history, corporate profile, the value of collateral, and income sources play key roles in cash credit approval.
Once approved borrowers do not require to maintain credit balance with banks, unlike other facilities.
Interest Charges and other Fees
Interest is charged only against the utilized amount from the facility. Interest rates are charged on daily rates.
Most banks also impose minimum interest rate charges regardless of utilization. There are also approval and processing fees with cash credits.
Unlike an overdraft, banks require collateral as a pledge to approve the cash credit facility. Collateral can be an asset of the company including assets, term deposits with banks, stocks, or any other valuable asset.
Cash Credit Term
Cash credits are short-term financing options ranging from one month to a maximum of twelve months.
Reputable and creditworthy borrowers can renew the cash credit facilities on rolling terms. Lenders also appraise the renewed collateral value at the time of renewal.
The borrowing limits and approval for the facility largely depend on the borrower’s creditworthiness.
Companies use the facility as a cash advance for managing the working capital requirements usually. It helps them smoothen the accounts payables and manage supplier relations.
Accounting Treatment of Cash Credit Facility
Cash credit is a bank loan, so the initial accounting entry will be to create a new account liability.
Initial journal entry:
Dr. Cash account
Cr. Cash Credit Loan
The repayment can be made in installments of a lump sum. As there are interest charges once the borrowers withdraw. Hence,
Dr. Interest Expense account
Cr. Cash Credit Loan
Entry for principal loan repayment:
Dr. Cash Credit Loan
The repayment may include an installment or in full as it is one type of revolving credit facility. Every time the business makes a full repayment, the entry must be settled against the cash.
Also, separate the interest charge and the principal repayment. The interest charges will be a recurring expense as long as the facility terms are valid.
Charge the interest expenses to the Income statement only. The accounting entries for the cash credit work similarly to any other short-term loan.
Once the cash credit facility reaches maturity, it will be settled against the cash in current assets and loan account in current liabilities.
Advantages of Cash Credit Facility
The biggest advantage of a cash credit resembles the name, as it helps maintain liquidity for any business.
Businesses often struggle to keep smooth relations with suppliers as they lack cash for payments.
Some key benefits of the cash credit facility include:
- It helps the business in managing the working capital requirements
- It improves the liquidity of the business
- It helps to improve the supplier and trade relations
- Cash credit is a flexible borrowing facility
- Businesses pay interest only on the utilized facility
- Banks approve the cash credit facility easily with collateral
- It reduces the tax burden as interest costs are tax-deductible expenses
Disadvantages of Cash Credit Facility
Having a drawing account with a cash credit facility improves the operational efficiency of the business. However, like any other loan facility, it also serves some limitations to the business.
- Interest rates charged with cash credit facility are higher than other loans
- It requires substantial and valuable assets to pledge as collateral
- The value of assets may deteriorate over time which can result in changing terms and interest costs
- Renewal of the facility is not automatic
- Banks often charge high service and processing fees with cash credit loans
Cash credit provides an important liquidity solution to a business in the short term. The flexibility and availability of cash credit make it an easier option for many businesses.