What is Cash Credit? Short Term Financing Sources

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 the 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 though.

Important Feature of a Cash Credit Facility

The cash credit facility is usually awarded to corporate account holders. The working mechanism of cash credit works similar 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 all 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 the amount of utilization. There are also approval and processing fees with cash credits.

Collateral Value

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 creditworthiness of the borrower. 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 type of 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 loan principal repayment:

Dr. Cash Credit Loan

Cr. Cash

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 works similarly to that of 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 with 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 that 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.

Sources of Equity Financing

Equity means a stake, ownership, or ownership rights in a business. Commonly, it is used synonymously as shares. Not all businesses can afford the listing of the company on stock markets. Yet, there are several options that small businesses can utilize to secure equity financing.

Any source of finance that comes with ownership rights can be termed as an equity financing source.

Shares – Initial Public Offerings

Initial public offering (IPO) is the most popular option for raising financing for growth companies. A business offers its shares on the stock market to raise finance. The IPO requires certain registration and compliance requirements from the company. The Securities and Exchange Commission provides the scrutiny on approval of an IPO.

IPO is a popular but expensive option for many businesses. A listed company has to publically share financial statements, governance policies, and other important business policies. The company’s valuation embeds public perception along with performance, hence the term “going public”.

A listed company has the option of raising equity financing by issuing more shares to the stock markets. These secondary rounds of issuing shares can be common or preferred stocks.

Crowd Funding

Crowdfunding is a cheap alternative for small or new businesses instead of an IPO. The business owners can issue shares to the public directly. The advantage of this option is that the business remains private and receives the funding. The owners can purchase back the sold shares to investors later unlike an IPO where the buyback is often difficult.

Venture Capitalists

Venture capitalists are usually interested in investing in new startups. Venture capitalists are a group of investment funds that seek returns on their investments. The investments can be in the form of debt or equity. Either way, these investors seek some control over company operations. Their interest is to ensure high returns on the investment. The borrowing business can buy back the shares issued to the venture capitalists later. Some companies use the option for project financing as well.

Investor Angels

Investor or business angels are individuals rather than companies seeking investments in growing businesses. They work similarly as venture capitalists apart from that investors here are individuals and they seek an ownership stake as well.

Investor angels are a popular financing source for tech startups. They provide alternative options to the IPO and crowdfunding as well. The cost of equity with investor angels is significantly higher though.

Investment Companies

Investment companies are regulated entities that seek investment returns from businesses. These companies pool funds from wealthy individuals or other businesses. Investment companies may also have funds from large banks, insurance companies, pension funds, Not-for-profit organizations.

Investment companies work similarly to venture capitalists. These are pooled funds that seek high returns in investments in startups or growing businesses.

Convertible Debt into Equity

These are hybrid funds that can be classified as either debt or equity. Convertible debt can be later converted into company shares. The borrowing company sets the conversion date and share prices before issuing such debts. The benefit of this option is to attract investors with large investors interested in debt financing. The lender keeps the option of selling the debt or converting it into equity in the form of shares.

Other Equity Sources

Some other forms of financing can be termed as equity financing. Some common examples of such equity financing are franchising, royalty-based investments, and sales-based financing. Each of these types of equity financing relates to company performance and sales. The investors do not directly own the company but a limited ownership right. The business framework or product trademarks are often the investment attractions in such financing options.

Advantages of Equity Financing

Technically equity financing means using other investors’ money in the business. Small businesses or entrepreneurship aside, other common forms of equity financing are using others’ money into the business.

It has certain advantages over debt financing:

  • It provides access to funds without collateral or assets.
  • It saves costs on interest payments.
  • Once issued through shares, it does not require repayment, unlike debt.
  • The company can choose between private investments or public shares.
  • It provides a valuation of the company to investors.
  • It adds credibility to the company profile with the listing.

Disadvantages of Equity Financing

  • Equity financing is difficult to secure for startups and small businesses.
  • The cost of equity is higher than the cost of debt.
  • The company loses control through the loss of ownership rights.
  • Investors and competitive authorities require strict compliance with the regulations.
  • The company needs to publically issue all business financial and governance statements to the shareholders.

Sources of Debt Financing

In layman’s terms debt financing means borrowed money. Lenders and creditors earn interest by lending money to the borrowers. The essential use of debt financing is providing financing to the business or individual. However, the implications of debt financing are stretched beyond financing to investments as well.

Debt financing can be classified by type, maturity, or lender. The characteristics of debt instruments depend on several factors. Usually, debt financing sources are classified into long-term and short-term options.

Long-Term Debt Financing Sources

Treasury / Government Bonds

These bonds are issued by government or treasury institutes around the world in capital markets. Investors seek regular returns with such investments. The creditworthiness of government institutes makes these bonds a secure type of debt financing.

Corporate Bonds

These are long-term debt instruments that large companies issue through capital markets. These are also secured loans but riskier than treasury issued bonds. The investors demand higher returns with these bonds than treasury bonds.

Bonds work as debt instruments for the issuers and investment options for the borrowers. Issuing bonds in the capital markets require substantial creditworthiness that makes it impossible for ordinary companies to raise financing through bonds.

Bank Loans

Traditional bank loans are the most common form of debt financing for all sizes of companies. Any bank loan with maturity over 12 months can be termed as a long-term debt source.

Borrowers require asset-backed collateral to secure bank loans. The absence of collateral can result in high-interest rate unsecured loans. However, bank loans are a widely used option for all companies. The bonds market remains an expensive and unreal option for regular businesses.

Financial Lease

Financial leases are long-term contracts that work like a loan. The lessee makes payments in installments against the ownership of an underlying asset. The maturity term of a financial lease is usually longer than one year.

Short-Term Debt Financing Sources

Revolving Credit Facility

It is a type of loan in which the borrower can reuse the loan amount on a recurring basis. The interest is only charged on the used amount from the approved total borrowing limit. The benefit with the facility is replenishing loan that does not require multiple loan approvals from the bank.

Lines of Credit

Lines of credit resemble revolving credit loans. The borrower can withdraw any amount up to the approved limit. Interest will be charged only on the utilized amount. However, unlike revolving credit, the line of credit facility does not replenish without approval. In a sense, it works as a hybrid of a short-term loan and revolving credit facility.

Overdrafts

Banks offer the facility to their creditworthy customers to allow flexible financing options. In this arrangement, an additional credit limit is approved with a normal bank account for the borrowers. The facility benefits companies in clearing issued payment instruments. It also works as an additional emergency buffer for individuals and businesses.

Business Credit Cards

Business credit cards also work like a line of credit facility. It can be used as a good short-term source of finance. However, the interest costs with credit cards are significantly higher than other types of loans.

Other Sources of Debt Financing

Some other forms of debt instruments can range from short to medium terms. The working nature of these types of debt instruments also differentiates them from common debt instruments.

  • Merchant Cash Advances
  • Operational Leases
  • Equipment financing
  • Trade and merchant loans
  • Factoring and Invoicing
  • Venture Capital Debts
  • Government and other Grants

Cost of Debt Financing

Generally, lenders of debt financing expect lower returns than equity investors. However, the cost of debt mainly depends on the secure nature of the borrowing. A secured loan will incur lower interest than an unsecured loan. Similarly, a short-term line of credit like a credit card (unsecured also) will incur higher interest costs.

Advantages of Debt Financing

Debt financing is accessible for all companies that make it the most widely used financing option. It offers certain benefits to both parties:

  • Debt financing is cheaper than equity financing.
  • It is an accessible and easily available option for all businesses.
  • Debt financing does not surrender the ownership rights of the business.
  • Debt financing instruments vary by type, thus offer a wide range of options for borrowers.

Limitations of Debt Financing

Although debt financing is a go-to option for most businesses, it comes with certain limitations:

  • Borrowers may need collateral to acquire debt financing.
  • It does not offer a certain qualification of the borrower.
  • Unsecured loans are expensive than equity financing.
  • Secured loans may result in foreclosure or bankruptcy in case of default on the loan.
  • High leverage with more debt financing may compromise the credit profile of the business.
  • High leveraged businesses may not qualify for equity financing as well.

Recourse Loan Vs. Non-Recourse Loan: The Top 5 Differences

All secured loans require collateral. The borrowers pledge an asset as collateral to get the loans. In case of default, the borrowers have the right to seize the collateral pledged. That is the reason, lenders prefer tangible assets with high market values. In many cases, borrowers default on a loan.

The collateral often does not fully recover the remaining amount of the loan. The legal actions associated with a default after a foreclosure differentiate a recourse and non-recourse loan.

Recourse Loan gives lenders the right to seize the pledged asset. In case of default, lenders can also go after any other asset or income source of the borrower.

In a non-recourse loan, the lender cannot seize any other assets other than the pledged one as collateral.

Most conventional bank loans work as recourse loans. Similarly, most mortgages and home equity loans work as non-recourse loans. Nature and legal rights associated with both types, make them totally at odd ends as the preference for both parties.

Some key differences in both types of loans are:

FeatureRecourse LoanNon-Recourse Loan
Parties in ContractBorrower and LenderBorrower and lender
CollateralPledged and other assetsOnly pledged asset
Borrower liability:Personally liableNot personally liable
Interest CostsLowerHigher
Credit RequirementsLowerHigher
Preferred byLendersBorrowers
Total costsLowerHigher

1) The Claim by the Lenders

In case of default on a loan, the legal claim on the assets held by the borrower makes the primary difference. The pledged asset or source of income remains at stake for both types of loans. However, in many cases, the pledged assets cannot recover the remaining balance of the default loan.

A recourse loan gives the lenders a right to seize any assets of the borrower in case of default. The lender may recover the remaining loan balance from other sources of income of the borrower.

In a non-recourse loan, the lenders can only seize the pledged asset only. If the market value of the pledged asset remains lower than the recoverable amount, the lenders do not have the right to seize any other assets.

In other words, the borrowers are personally liable for default in a recourse loan only.

2) Credit Score Requirements

This leads us to the secure nature of both loan types. With more powers to the lenders, a recourse loan becomes less risky. A non-course loan is less secured for the lenders. Lenders always prefer secured loans over non-secured loans. Hence the credit score required for a non-recourse loan will always be higher.

Lenders will accept somewhat lower credit scores in a recourse loan if the borrower possesses substantial assets. These assets do not offer much to lenders in a non-recourse loan though.

3) Interest Rates

As we all know, lenders certainly charge higher interest rates with non-secured loans. A non-recourse loan offers less security to the lender, hence they charge higher interest rates. Contrarily, the interest rates will be lower for a recourse loan.

The total interest costs associated with a loan depend on some other factors too. For example, the central bank interest rate (LIBOR) plays an integral part in determining the total interest costs of a loan. However, the prime interest is decided by the lenders on the nature of the loan.

Borrowers will be better off in recourse loans as far as the interest rates are concerned. Although, borrowers risk more assets with recourse loans in case of loan defaults.

4) Collateral Value and Credit History

Some assets depreciate in value quickly. These pledged assets for loans offer risky options to the lenders. For example, in an auto loan, the market value of the car significantly falls the moment car hits the roads. For that reason, an auto loan will almost always be a recourse loan.

Lenders will demand stricter conditions with a non-recourse loan. A lower debt-to-income ratio, high market value of the asset, and clean credit history. Thus qualifying for a non-recourse loan will be more difficult for the borrower.

So if the credit score of the borrower is lower, the lender would ask for a high-value asset as collateral. In other words, with a lower credit profile, the lenders would prefer a recourse loan.

5) Tax Considerations

The tax implications for both types of loans can vary depending on the foreclosure type. If the lenders can recover the full remaining balance of the loan after a foreclosure, there will be no repayments. In most cases, the loan forgiveness balances occur in a recourse loan.

The lenders return the forgiveness loan amounts above the remaining loan and legal charges, which may result in a tax bill for the borrower.

Any proceeds after the collateral seizure and loan forgiveness are usually considered taxable income for the borrowers.

Lease V Rent Decision for a House – Top 5 Factors to Consider

The terms lease and rent are used interchangeably. Such use of these terms can often lead to confusion for the tenants. Both terms offer significantly different options to both parties in the agreement.

The main difference between these two terms remains the choice of house ownership at the end of the agreement. There are few similarities too with both terms. Both types of agreements are legally binding contracts. Breach of such a contract can result in severe litigation actions and other legal consequences.

Here are a few similar points that are included in both Lease and Rent Agreements.

  • The two parties signing the contract
  • Duration of the contract
  • Payment terms and price
  • A security deposit or down payment amount
  • The terms at the expiry of the contract
  • Terms and conditions for the house maintenance

Let us first take a glance at the summary of Differences between the two Agreements.

FeatureLeaseRent
Parties in ContractLessor and LesseeLandlord and Tenant
DurationLong-termShort-term
PaymentsMonthlyMonthly-Quarterly
Maintenance and DamagesLesseeTenant, the landlord with a short-term contract
Ownership of the HouseOption to buy for the lesseeNo option to buy for the Tenant
Alteration during ContractNo Alterations, rent changeAlternations possible during the contract
Contract TerminationsNo termination before ExpiryCan be terminated

Here are the top 05 factors discussed in detail.

1) The Agreement Duration

Lease agreements are made for a longer period. Usually, a lease period lasts for one year but can range from 03 months to several years. The duration of the lease period significantly changes with the type of lease. For example, a house lease-purchase will usually be longer than a Lease-Option agreement.

The rent agreements are made for a shorter period. The rent agreement can range from 01 months to 12 months. Some real estate firms also offer to rent agreements for less than one month.

The duration terms offer more flexibility to the tenant with rent and stability to the landlord with a lease agreement.

2) Terms and Conditions

All terms and conditions are agreed upon in advance for both types of agreements. The difference is that rental agreements can be altered during the term period. Once a lease agreement is signed, both parties cannot alter any terms before the expiry date.

The alteration clause may be important for tenants as the landlords may change the rent price or ask for property eviction. The lessee, on the other hand, is more secure with binding terms and conditions.

3) Down Payment and Security Deposit

Both agreements require some upfront costs. The rent agreement usually takes a security deposit of at least one month’s rent amount. It may also include some cover for the maintenance and damage costs.

Lease agreements usually require a portion of the house price as a down payment. In the case of a house Lease-Purchase agreement, the down payment works similarly as in a mortgage. However, a lease-option agreement may only include a security deposit.

4) Maintenance and Other Costs

All house maintenance and damage costs are covered by the lessee in a lease agreement. The same will hold true for a tenant if the rent agreement is for a significant period. Short-term rent agreements for 01-03 months usually exclude the maintenance costs.

In house agreements where no maintenance or damage costs are included, the landlord usually includes an insurance fee. The rent prices are also higher in such cases.

5) Ownership of the House

The biggest difference in a house renting or leasing options is the ownership of the house. Renters never own a house even if the rent agreement gets renewed for several years. The lease agreements work in two ways that offer different options to both parties.

The House Lease-Option Agreement

This lease agreement includes a clause that includes an offer to the lessee after a specific time to purchase the house. The house price gets determined at that time. Until that period, the lessee pays regular lease installments. This type of lease agreement offers flexible options to both parties.

The House Lease-Purchase Agreements

This lease agreement includes a certain term that the lessee will purchase the house at the end of the lease period. The lease installments, house price, the down payment, and the lease period are all decided in advance. Both parties are then legally bound to abide by the agreement.

Until the lease contract, the lessee makes payments in installments. These installments can include the amount for rent + the contribution towards the house price.

Lease V Rent A House – Which option is the best one for you?

If we take out the option of owning the house, we can still see some major factors to decide between a lease v rent decision.

Here are a few key differences to keep in mind before you decide:

  • Renting is a better option for a Short-term period
  • Leasing is affordable for long-term contract
  • Consider the maintenance and damage costs
  • Evaluate the availability and proximity of the house
  • Renting offers more flexibility, leasing offers more stability

Paid in capital Vs. retained earning?

For any company, the shareholder’s equity portion of its Statement of Financial Position will consist of different equity instruments and reserves. Among these, the most common are paid-in capital, additional paid-in capital, and retained earnings.

Each of these balances represents a different aspect of the equity of a company. While these are all a part of the equity of a company, there is still some difference between them.

To better understand the similarities and differences between these balances, it is crucial to understand what each of these balances represents. Below is a general description of these balances.

What is Paid-in Capital?

Paid-in capital is a balance is the equity of a company that represents the par value of its issued shares. Every share issued by a company has a par value, which denotes the value of the share set in the corporate charter. That means the par value of a share does not change from one issue to another.

Therefore, the paid-in capital balance only consists of the total par value of all the issued shares of a company. The more share a company issues, the higher its paid-in capital balance is going to be.

Paid-in capital can also exist for the preferred shares of a company. Preferred shares are shares that give the shareholder a preference when it comes to dividends, and in case the company liquidates.

Preferred shares, like ordinary shares, also have a par value or face value, which the company defines beforehand. For all the preferred shares a company issues, it must record the total amount of their par value in the paid-in capital account.

For most companies, issuing shares will also give rise to another balance known as the additional paid-in capital balance. While this balance is closely related to the paid-in capital balance, and often depends on it, it represents a different aspect of equity.

What is Additional Paid-in Capital?

Additional paid-in capital consists of any additional amount above the par value of a share that a company receives for new share issues. The actual price a company charges for newly issued shares will almost always be different from its par value.

The actual price depends on various factors such as market conditions, company performance, environmental factors, etc. The company must split the paid-in capital amount from the total receipt for new shares and record the remaining amount in the additional paid-in capital account.

While additional paid-in capital balance represents a different amount and balance than the paid-in capital balance of a company, both of them are very closely related.

They make up the total equity a company received from its shareholders in exchange for issued shares, also known as contributed capital. There are also some rules and regulations that companies must follow when it comes to paid-in and additional paid-in capital balances.

What is Retained Earnings?

Retained earnings are also a part of the shareholders’ equity of a company. However, retained earnings do not relate to the finance a company generates from its shareholders. Instead, retained earnings represent the internally generated finance of a company that it makes through its operations.

The retained earnings of a company usually comprise of its accumulated profits less any dividends it pays to its shareholders.

A company generates profits through its operations. Sometimes, it may also make a loss instead of a profit. Either way, the retained earnings of a company reflects its performance over its lifetime. Retained earnings is also a type of finance that a company can use in its operations.

It is the lowest cost finance that a company can use since the company generates it internally. However, retained earnings may be finite depending on the resources and performance of the company.

Unlike with paid-in and additional paid-in capital, a company can distribute its retained earnings. Therefore, retained earnings represent the distributable profits of a company. These distributions come in the form of dividends. Every time the company pays dividends to its shareholders, it must deduct them from its retained earnings.

When companies initially start, their paid-in capital and additional paid-in capital balance will exceed their retained earnings balance. However, as they establish themselves and make profits, their retained earnings balance can exceed their paid-in and additional paid-in capital balances.

However, if they make a lot of losses instead of profits, the retained earnings balance may also become negative or go into a deficit. Paid-in and additional paid-in capital balances will never become negative for companies.

Conclusion

Three main balances will exist in the shareholders’ equity of companies including paid-in capital, additional paid-in capital, and retained earnings. Paid-in capital represents the total par value of the issued shares of a company, and additional paid-in capital represents the amount in excess of the par value of shares a company receives.

Lastly, retained earnings represent the total profits minus the total dividends paid by a company. Paid-in and additional paid-in capital are similar and often related to each other. However, they are different from retained earnings.