Understand the difference between Cash Credit and Overdraft
To run a successful business, you must always have sufficient funds to meet your operational expenses. In the event of a cash crunch, financial institutions now provide a variety of financing choices to assist you with your funding needs. Among these alternatives, cash credit loans and overdraft facilities are two of the most regularly used loan products. Though most people mistakenly believe that both of these products are identical, they are actually quite distinct. In this blog, we help you understand cash credit and overdraft while also highlighting the key differences between them.
What is a Cash Credit Account?
A cash credit loan is a sort of short-term lending offered by financial institutions to small businesses to help them meet their working capital needs. Businesses can use this funding option without having a credit balance in their account.
How Does Cash Credit Work?
Cash credit is a type of working capital loan that is available for 12 months tenure. It allows businesses to withdraw funds from their account in excess of their account balance as often as they desire, up to a predetermined borrowing limit. On the successful completion of the loan term, the cash credit limit is renewed. Under this financing arrangement, the interest is applicable only on the withdrawal amount and not on the entire borrowing limit.
The following is a list of factors that go into determining the cash credit loan eligibility and your borrowing limit.
- Credit history
- Positive credit score
- Type of collateral provided
- Business' current assets and liabilities
Businesses can use the funds to cover expenses such as purchasing raw materials, paying wages, and utility bills, among other things.
Key Features of Cash Credit Loan:
Now that you have learned about the cash credit loan, it's time to learn about its features.
- Cash credit loans can be utilised only for your business.
- To get cash credit funds, you need to open a separate bank account.
- To approve a cash credit loan, financial institutions usually require borrowers to put up collateral.
- Under this financing arrangement, you have the option of repaying your loan daily or weekly. However, the cash credit account rules, terms, and conditions are pre-specified.
- Under this financing arrangement, there are no restrictions on the transaction numbers and the cheque books issued for the cash credit account.
- If you are applying for this loan, you will need to submit your GST filing, balance sheet, and profit and loss statement quarterly and annually.
What is an Overdraft Facility?
An overdraft is a facility offered by a financial institution that allows an account holder to borrow up to a particular amount whenever the account balance reaches zero. The financial institution charges an interest rate, or say, an overdraft fee only on the amount withdrawn from the overdraft account. The borrowed amount must be repaid within a specific time frame.
How does Overdraft Facility Work?
When you request for an overdraft facility or when you have a pre-approved overdraft limit, then post-approval, you have the option to overdraw funds from your account up to a predetermined limit. Using the overdraft limit means you are raising your account's outstanding balance. The outstanding balance reduces as soon as you deposit the funds into your account.
Under this financing arrangement, you have the option of repaying the lender in full or in part. Once you repay the lender, you can again overdraw the funds until your overdraft limit is exhausted. To understand the working of an overdraft facility, let's take an example.
For eg, a business owner has to pay a salary of Rs 10 lakh. However, he only has Rs 7 lakh in his current account because his payments are delayed by his customers. If he has an overdraft account with a limit of over Rs 3 lakh, he can withdraw the amount he falling short of and cover his expenses.
Interest here will be levied on the money drawn from the overdraft account, until it is fully paid back.
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Key Features of Overdraft Facility:
- Overdraft facility is available to those who have a strong relationship with the lender and have a considerable investment or account with them. Hence everyone might not be able to get this facility.
- Financial institutions levy a fee on any additional funds you withdraw from your account. Fees differ from one lender to the next.
- Even if you hold a joint account, you can apply for an overdraft facility. However, in this case, both account holders are equally responsible for repayment.
- An overdraft facility has a different repayment pattern than a regular loan. In this case, the lender does not set up an EMI, and they are payable on demand.
Cash Credit vs. Overdraft Key Differences
Before you make a decision, let us first analyse the key differences between these two financing choices.
| Parameters | Cash Credit Loan | Overdraft Facility |
|---|---|---|
| Purpose | Available to businesses for meeting working capital requirements. | Available to both businesses and individuals for meeting their short term financial obligations. |
| Basis | Cash credit loan is provided based on the availability of business stocks and inventories. | Overdraft facility is provided based on the applicant's relationship (amount of investment held, type of account, etc.) with the financial institutions. |
| Interest Rates | Cash credit interest rates are lower than overdraft facilities. | When compared to cash credit, overdraft interest rates are slightly higher. |
| Account Opening | You need to open a new account to receive the cash credit loan amount. | You can avail of the overdraft facility from your existing account. |
| Loan Tenure | Cash credit loans usually have a one-year repayment period. | Overdraft facility repayment tenure can be monthly, quarterly, half-yearly, or yearly. |
| Loan Amount | Under this financing arrangement, the sanctioned amount does not decrease with time. | Under the overdraft facility, the sanctioned amount reduces monthly. |
Some Key Similarities Between Cash Credit and Overdraft Facility
Apart from differences, there are also some similarities between an overdraft facility and a cash credit account that you should be aware of.
Interest Calculation:
Whether it's an overdraft or a cash credit, the financial institution charges interest based on the amount withdrawn and not on the amount sanctioned.
Maximum Amount:
In both the financing arrangements, the maximum amount sanctioned is fixed, and you cannot qualify for an additional amount.
Repayment:
Whether it's a cash credit loan or an overdraft facility, both of these financing arrangements are payable on demand. These two types of finance options do not have any prepayment fees.
RELATED READ: What are commercial loans in India?
Some Points to Remember in Cash Credit and Overdraft Facilities
- Interest Rate: Compare the interest rates offered for cash credit and overdraft facilities. Cash credit typically offers lower interest rates.
- Foreclosure Charges: Be aware of foreclosure charges applicable if you close the credit facility before its tenure ends. These charges usually range from 1% to 2% of the outstanding amount.
- Processing Fee: Check the processing fees associated with availing the credit facilities. Understand the costs involved upfront.
- Loan Amount Utilization: If you opt for cash credit but do not fully utilize the sanctioned amount, banks may still charge interest on the unused portion.
- Penalty Charges: Some banks impose penalty charges, including penalty interest, for late payments or other breaches of terms.
- Consider Your Business Needs: The choice between cash credit and overdraft depends on your business's specific requirements and financial circumstances. Assess which option aligns best with your cash flow management and funding needs.
These pointers help businesses make informed decisions when considering cash credit or overdraft facilities, ensuring they choose the most suitable option for their financial operations.
Considerations When Choosing Between Cash Credit and Overdraft
When deciding between cash credit and overdraft facilities, several important factors should be taken into account to ensure the choice aligns with your financial needs and goals:
- Business Needs Assessment: Evaluate your business's cash flow requirements and funding needs. Consider whether you need ongoing access to funds (suitable for cash credit) or occasional flexibility to cover short-term expenses (suitable for overdraft).
- Cost Effectiveness: Compare the total costs associated with each facility, including interest rates, processing fees, and potential penalty charges. Assess which option offers the most cost-effective solution based on your usage pattern and repayment capabilities.
- Risk Management: Understand the risks associated with each facility. For cash credit, be aware of interest charges on both utilized and unutilized amounts, and consider how fluctuations in cash flow may impact repayment. With overdrafts, assess the risk of exceeding limits and incurring penalty charges for late payments.
- Flexibility of Repayment Terms: Consider the flexibility offered in repayment terms. Cash credit usually involves structured repayments with interest on the utilized amount, whereas overdrafts often allow for more flexible repayment schedules, including payments on demand.
- Relationship with the Lender: Evaluate your existing relationship with the lender. Some banks may offer preferential terms or higher credit limits based on your history and relationship, which could influence your decision.
- Long-term vs. Short-term Needs: Determine whether your financial needs are short-term or long-term. Cash credit may be more suitable for ongoing operational needs, while overdrafts provide immediate liquidity for unexpected expenses or temporary cash flow gaps.
Conclusion
Both cash credit loans and overdraft facilities are useful financial tools that help small businesses meet their working capital requirements. However, before making a decision on whether to take a CC or an OD, consider the interest rate, processing fees, and other features of both products.
In conclusion, choosing between a cash credit loan and an overdraft facility depends on your business's specific financial needs and operational requirements. Cash credit offers structured repayment terms with lower interest rates, ideal for ongoing working capital needs. On the other hand, overdrafts provide flexibility for short-term cash flow gaps but may have slightly higher interest rates. Assessing these factors will help you make an informed decision that aligns with your business goals and financial capabilities.
Frequently Asked Questions
1. Who can apply for a cash credit loan or overdraft facility?
Businesses with a good credit history, stable cash flow, and sufficient collateral can apply for cash credit loans. Overdraft facilities are available to account holders with a reliable banking relationship and creditworthiness.
2. What documents are needed to apply for cash credit or overdraft?
Typically, applicants need to provide financial statements, business plans, collateral details, and proof of identity and address for both cash credit and overdraft facilities.
3. Which option is more suitable for my business?
Choose cash credit for consistent working capital needs with structured repayments. Opt for an overdraft for flexibility in managing short-term cash flow gaps and unexpected expenses.
4. Are there any fees associated with cash credit and overdraft facilities?
Both options may have processing fees, interest charges on withdrawn amounts, and potential penalty fees for late repayments or breaches of terms.
