Need for credit and its nature, Financial Management

Need for Credit and its nature

On the demand side of the economy are the consumers of goods and services who require funds basically for acquiring certain consumer durables. The credit facility offered to the households will generally be in the form of auto-finance, educational loans, credit card loans, housing loans and for the purchase of other consumer durable items. Loans will also be provided to individuals against other financial and real assets. Except for the housing loans all the other types of individual loans range from short- to medium-term.

Similarly, on the supply side also, the credit market provides funds to the corporates, though for entirely different purposes. Corporates basically require funds for project finance while initiating an investment plan and working capital finance for their day-to-day operations.

Credit extended for project finance would enable the corporates to acquire real assets, plant and machinery, technological expertise, etc., required for expansion/ modernization/diversification purposes. It can be observed that the funds required for these purposes will be large in amount and for periods ranging from medium- to long-term.

In certain cases, where the project is very large and the funds cannot be provided by a single institution, consortium lending will be resorted to. In this facility, two or more intermediaries will join together to finance large project proposals. Such funding requirements will generally arise while financing large infrastructure projects, petroleum projects, etc.

In addition to the long-term requirements, firms would also require short-term funds for meeting their working capital requirements. Firms require these funds to meet their day-to-day operational requirements and for maintaining adequate levels of current assets. Since these funds support the daily operations of the firms, they are required on a continuous basis. The financial assistance for the working capital requirements is generally provided by banks in the form of Cash Credit (CC), Overdraft Facility (OD) and bill finance.Under the cash credit facility, limits are set based on the requirements of the firm and the CC is sanctioned for one year. The CC limits sanctioned for a year, in practice, will generally be renewed after assessing the working capital requirements for the following year. Thus, the cash credit has a permanent feature, though, technically the funds are repayable on demand. The CC limit sanctioned based on the working capital estimates will have the combined features of a loan and a current account. Funds will be made available through an account of the firm from which the firm can withdraw (within the sanctioned CC limits) when funds are required and deposit when funds are in excess. The interest charged will be on the daily outstanding (net debit balances) in this account and will generally be paid on a quarterly basis.

In the overdraft facility, the bank will allow the firm to overdraw from its current account to a predetermined level of credit. This credit limit will be set based on the security offered by the firm. Such type of credit facility will generally be short-term in nature, not exceeding a year.

The other type of short-term credit will be in the form of bill financing. Here, the intermediary will finance the trade bills of the firm for a period ranging up to
6 months. The overdraft facility is either clean or against some security such as real estate whereas cash credit account is invariably secured by inventory.

While the short-term and the long-term credit facilities mentioned above appear on the balance sheet of the firm, there are a few contingent credit facilities which do not appear on the balance sheet. These off balance sheet activities are generally in the form of letter of credit or a standby facility or guarantees. The contingent claim is transformed into a credit claim when the contractual obligation is activated. The returns on such off balance sheet transactions are high, but so are the risks.

Apart from the above, the credit market in a few economies also facilitates priority sector lending. As per the regulations of these economies, a prescribed percentage of the total loanable funds of the intermediaries will have to be utilized to fund the priority sector. In India, banks are required to allocate 40 percent of the total funds provided as loans in that year towards the priority sector lending. For a developing economy such selective credit control becomes essential to ensure the proper use of institutional credit since a major portion of the savings lie with these intermediaries as loanable funds.

 

Posted Date: 9/11/2012 3:28:57 AM | Location : United States







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