avenues to raise short term sources of funds.

1. Group 6
1 November 2014
Working Capital Management
Cash Credit, Overdraft and Bank Guarantees
Cash Credit
Cash Credit is a facility to withdraw the amount from the business account even though the account
may not have enough credit balance. This drawing power is determined based on the value of
securities submitted by the borrower.
Purpose
Cash credit fulfils the short term loan requirements. Working capital does not need a long term loan
as repayment does not require long time, thus cash credit can be availed.
Example (To understand how it works)
Suppose a person is running a business. To carry out his business he requires working capital. This
can be either funded by the businessman or if he doesn’t have enough money, he can take a loan i.e.
Cash credit. The entire working capital requirement will not be funded by the bank, a part of this
will be funded by the businessman himself and the balance will be funded by the bank.
The amount so worked out is given as loan and is called as “limit” this is because under this kind of
loan the borrower may not take up the entire amount of loan, as working capital requirement every
day is not the same. In this case the working capital requirement is as following:
Day 1: Rs 92,000
Day 2: Rs 96,000
Day 3: Rs 1,07,000.. and so on ( different for different days)

2. If in the above e.g. Limit is say Rs. 1 lakh then when he requires Rs. 1,07000 he will get loan up to
Rs. 1 lakh only.
The reason why he should borrow different amounts on different days as per the amount required by
him on that day is that the interest calculated is on daily basis on the amount borrowed by him on
different days. i.e. if amount required by him say on a particular day is say Rs.92,000 but he takes
entire amount Rs. 1,00,000 he will have to pay interest on entire amount of Rs. 1 lakh. However if
he would have only taken say Rs. 92,000 which he required he would have to pay interest on Rs.
92,000 only and not on Rs 1,00,000.

3. Bank Overdraft Facility
It is an extension of credit from a lending institution when an account reaches zero.
An overdraft allows the individual to continue withdrawing money even if the account has no
funds in it. Basically the bank allows people to borrow a set amount of money.
IT IS BASICALLY LIKE A CREDIT FACILITY GIVEN BY A BANK
Features
1. They are available only on current accounts.
2. The bank will assess your credit-worthiness based on a historical study of your account
operations and it fixes a limit for you, as a customer, to access an OD facility.
3. The facility will be automatically activated the moment your account balance reaches zero.
(There are two types of overdraft facilities)
1.Secured 2. Unsecured
4. The rate of interest payable on such facilities usually ranges from 12 to 14% per year.
Advantages
1. If you have an overdraft account, your bank will cover checks which would otherwise bounce.
2. It ensure that a level of liquidity can be maintained in the business.
How to go about it?
The process is similar to taking any other loan. You can offer your bank a host of collaterals,
such as your house, shares, bonds, insurance policies, fixed deposits and obtain such overdraft facility.
But each one of these has their own upsides and downside.
AMOUNT OF CREDIT
For example, taking an overdraft against property though allows you a larger line of credit as
compared to a fixed deposit in absolute terms, property evaluation will take some time. However, the
bank will be much quicker while sanctioning overdraft against fixed deposits.

4. Banks consider surrender value of life insurance policies while offering overdraft. Rajiv Raj says there
are banks who selectively offer temporary overdraft facilities against salary of an individual. For
example, if you have a salary of Rs 1 lakh a month, there is a credit line of Rs 50,000 available to
you, the salary credited is adjusted against the credit outstanding at the end of the month.
MARGIN REQUIREMENT
You have to also factor in the 'haircut' - the margin of safety - the bank will take. For example, the
bank will be comfortable in approving limit up to 50% of the value of the property but in case of a
fixed deposit, may offer up to 70% of the fixed deposit amount.Depending upon the limit you need,
you should choose the collateral.
ONE TIME FEE
Along with the collateral, banks charge a small one time fee - 0.5 to 1%, subject to a cap of, say, Rs
25,000. This is especially true when you are offering property as collateral as the bank has to conduct
due diligence on the title and value of the property.
LIMITS ARE REVISED
Overdraft limits are approved for a year, and the bank typically reviews them each year. Should you
go for it? Financial experts say, overdraft facility is meant for disciplined individuals. This is because
many people tend to misuse the funds. "It is a credit line available with you, and if you use it to fund
speculative activities such as short-term trading in stocks, commodities or currencies, it may backfire,"
says Harshvardhan Roongta.If you lose in such speculative adventures, you have to pay for it in
addition to the interest accrued on the overdraft availed. And if you fail to pay on time, the bank may
liquidate the asset.

5. Difference between Cash Credit and Overdraft
1. Overdraft is a temporary arrangement and is usually for a very short period. The cash credit on
the other hand is a borrowing on a comparatively long term and on regular basis. Cc is a
permanent limit given by the bank and over draft is given for a particular period like 10 days 15
days or so and it is done in current a/c.
2. Overdraft facilities are allowed in current account only. Cash credit needs opening a separate
cash credit account.
3. The rate of interest on overdraft is relatively lower but on cash credit it is higher.
4. Overdraft is against paper securities i.e. Current Assets in the form of Receivables, Bonds,
Certificates, etc. whereas Cash Credit is against tangible securities i.e. Current Assets like Stock-
in-Trade.
Similarity between Cash Credit and Overdraft
1. They both are used for financing working capital requirements.
2. Both are used by customers when they want to withdraw cash under credit till a specified
predetermined limit.
3. Interest is charged only on the cash borrowed, and not on the limit specified.

6. Bank Guarantees
A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other
words, if the debtor fails to settle a debt, the bank will cover it.
1) THERE ARE THREE PARTIES TO THE GUARANTEE.
2) The person who gives the guarantee is called “SURETY”.
3) The person on whose behalf the guarantee is given is called the “PRINCIPAL DEBTOR”.
4) The person in whose favour the guarantee is given is called the “CREDITOR OR
BENEFICIARY”.
Types of Bank Guarantees
A. Financial Guarantee
A guarantee which is issued in lieu of monetary considerations. For example, tender deposits, sales
tax payments , retention money, etc.
Advance Payment Guarantee
The advance payment guarantee serves as collateral for the reimbursement of an advance payment
made by the buyer in the event the seller does not supply the ordered goods at all or as contractually
agreed.
To make a claim under this guarantee, the beneficiary is generally required to declare in writing that
the seller did not fulfill his or her contractual obligations properly.
Payment Guarantee
The purpose of the payment guarantee is to assure the seller that the purchase price will be paid on
the agreed date. A payment guarantee can be issued as an alternative to a letter of credit. However, it
must be remembered that a payment guarantee does not offer the buyer the same level of security as
a documentary credit. The documents required under a bank guarantee are merely checked against
the details given in the guarantee itself, and not to the same extent as with a letter of credit.
To make a claim under this guarantee, the beneficiary is generally required to declare in writing that
he or she has fulfilled all of his or her contractual obligations but not received any payment as of the
due date.

7. Credit Security Bond
The credit security bond serves as collateral for the repayment of a loan. A loan is often made subject
to the provision of collateral by the borrower him or herself or a third party.
The beneficiary can generally assert claims under this guarantee by declaring in writing that the
borrower has not repaid the loan upon maturity.
Rental Guarantee
The rental guarantee serves as collateral for payments in connection with a rental agreement. It is
either limited to the payment of rent installments or covers all payments owed in connection with the
rental arrangement (e.g. repair costs following the termination of the rental arrangement).
To make a claim under this guarantee, the beneficiary is generally required to declare in writing that
the tenant did not fulfill his or her contractual obligations under the rental agreement properly or at
all.
Payment Guarantee
The purpose of the payment guarantee is to assure the seller that the purchase price will be paid on
the agreed date. A payment guarantee can be issued as an alternative to a letter of credit. However, it
must be remembered that a payment guarantee does not offer the buyer the same level of security as
a documentary credit. The documents required under a bank guarantee are merely checked against
the details given in the guarantee itself, and not to the same extent as with a letter of credit.
To make a claim under this guarantee, the beneficiary is generally required to declare in writing that
he or she has fulfilled all of his or her contractual obligations but not received any payment as of the
due date.

8. B. Performance Guarantees
A guarantee which is issued in respect of performance of a contract or obligation.
In event of non performance of obligation in terms of contract, the bank assumes only monetary
liability upto a specified amount.
Warranty Bond
The warranty bond serves as collateral to ensure that ordered goods are delivered as promised/
agreed.
To make a claim under this guarantee, the beneficiary is generally required to declare in writing that
the exporter did not fulfil his or her warranty obligations as contractually agreed.
Bid Bond
Bid bonds are frequently demanded in connection with public invitations to tender. The purpose of
the bid bond is to prevent companies from tendering bids but not accepting or executing the contract
once it has been awarded to them. The buyer wishes to safeguard against the submission of frivolous
or unqualified tenders.
To make a claim under this guarantee, the beneficiary is generally required to declare in writing that
the bidder did not sign the relevant agreement within the defined time frame after being awarded the
contract, and/or did not provide the required performance bond.

9. Examples :
Lets say the Government takes the decision to offer the construction and operation of a highway as a
grant of contract, an international call for tenders is issued. Once the offer is up in the market
various companies submit their tenders including various documentations required. Construction
jobs involve a lot of work and capital, it is important for the Government to ensure that the
contractors coming in are up to the task. A good way to ensure this is to place upon them the
obligation to make compensation if they do not deliver on the tasks as agreed upon. This begins right
from the start of the project. Construction projects involved a serious bidding process where
candidate construction firms are thoroughly scrutinised before selections are made. It is a very taxing
process and many project owners, in this case the Government will require bid bonds. Continuing
with our example, the company which offers to complete the project incurring minimum cost
( bidding the lowest price ) is given the project. In this case lets say companies A, B and C submitted
their respective tenders where ;
Company A quoted ₹11,000 crores
Company B quoted ₹ 10,000 crores
Company C quoted ₹10,500 crores
Evidently it is Company B that gets the project after which it needs to commence the construction
of the highway. Bid Bonds are a guarantee that should a company be chosen, they will begin work as
indicated on the advertisement of the job. Once the project begins the bond expires. However, failure
to begin work means the project owner (government) has to go through the process of choosing an
alternative contractor. As compensation of time, effort and money wasted in picking the initial
bidder, the project owner can cash in the bond from the surety. The premium payable ranges from
1 - 3 % of the contract amount.
Another type of bond is the performance bond. This bond guarantees that the contractor
chosen will perform the job to the expected terms of the contract. This means the quality of work
and schedule agreed upon must be adhered to. Failures in delivery can result in the performance
bond being also cashed in. The premium payable ranges from 1 - 15 % of the contract amount. The
premium depends on the contract type, contract amount and the application risk.
Maintenance bonds are another common request from contractors. They guarantee that they
will maintain the construction for a determined period of time. The premium payable commences
from less than 1% and changes according to the risk involved in the project. Payment bonds are
used when the contractor lacks adequate capital to pay suppliers and subcontractors. It guarantees
that when the contractor is paid by the project owner by a specified date, he will submit payment to
these other parties.

10. Difference between Letter of Credit and Bank Guarantees
A bank guarantee and a letter of credit are similar in many ways but they're two different things.
Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss
if the transaction doesn't go as planned.
A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are
met. Once these terms are completed and confirmed, the bank will transfer the funds. This ensures
the payment will be made as long as the services are performed.
A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line
of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under
the contract. This can be used to essentially insure a buyer or seller from loss or damage due to
nonperformance by the other party in a contract.
For example a letter of credit could be used in the delivery of goods or the completion of a
service. The seller may request that the buyer obtain a letter of credit before the transaction occurs.
The buyer would purchase this letter of credit from a bank and forward it to the seller's bank. This
letter would substitute the bank's credit for that of its client, ensuring correct and timely payment.
A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash
flow difficulties and can't pay the seller. The bank guarantee would pay an agreed-upon sum to the
seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the
purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the
opposing party in the transaction.