What is Commercial Credit?
Commercial Credit is an on-demand loan credit facility that is pre-approved by the bank or the lender and is usually availed for urgent cash requirements or working capital needs. Unlike loans where the borrower will be charged interest on the entire loan, the such a credit feature helps borrowers to pay interest only on the amount withdrawn. Most commercial credits are revolving, that is there is a limit, once you withdraw and payback, the credit is free again.
Types of Commercial Credit
There are mainly two types:
#1 – Secured
In Secured Commercial Credits, the bank charges collateral to enter into an agreement with companies. So if the company fails to make the payment, then the bank has the right to liquidate the collateralCollateralCollateralization is derived from the term "collateral," which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay. and use the money to clear the outstanding payment. As the credit is secured, so the interest charged is less, and the limit is high.
#2 – Unsecured
Unsecured Commercial Credits are not backed by collaterals. So the credit lineCredit LineA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business. is risky. Banks usually charge higher interest rates in this case, and the credit limits are also less.
How Does it Work?
Companies require cash to deal with day to day expenses or sudden capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. requirements. So to avoid a cash crunch, they enter into a commercial credit agreement with banks. Commercial Agreement is a privilege provided to companies by banks, where a limit of withdrawal is set by the bank, which can be enjoyed by the companies. There will be no interest charged if the company doesn’t withdraw any money. So it is a kind of preapproved loan, but the interest is not charged on the entire limit. It keeps on revolving. As and when the company pays back the withdrawn money, the account starts to refill and allows companies to withdraw again in the future.
Example of Commercial Credit
Company XYZ has entered into a commercial credit agreement with a bank with a limit of $1,000,000. Due to the current COVID-19 situation, company XYZ is suffering a huge decline in sales. The fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. of the company is constant. So to pay the fixed cost, the company XYZ will have to use its commercial credit and will have to wait for the situation to recover. It is extremely helpful during emergencies.
- This helps companies to meet the urgent requirement of cash. This inculcates security in the minds of managers as they know that daily operations will not be hurt due to cash requirements
- As the rate of interest is already fixed, so it helps managers to avoid taking high-interest loans during emergencies.
- If there is a limited period discount on any asset that is being needed by the company, then the company can use the commercial credit to buy the asset and increase productivity.
- It helps the company to invest in long term illiquidIlliquidIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment. securities to earn more interest. As such, a credit will take care of sudden liquidity requirements, so they will not have the requirement to liquidate illiquid assets. There is always a liquidity premiumLiquidity PremiumLiquidity premium refers to the extra compensation desired by the investors for holding assets that are either difficult to be converted into cash or tradable in the open market at a fair price. in illiquid assets.
- It helps to create a healthy relationship with the bank. Consistent payment of withdrawals and proper, timely payment of interest will help companies to achieve a high credit rating.
- Companies start to think that it will protect them from meeting expenses and, in turn, increases the expense. So increases the risk of lower profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount.
- If timely payments are not made, then the interest burden increases, which gets difficult for companies to pay back.
- Failure in payment may lead to poor credit rating, which will increase the cost of funding for the company in the future.
Commercial Credit is a privilege given to companies and should be used with caution. The money withdrawn is not interest-free, so it should only be used when required. It helps companies to operate optimally as a sudden liquidity requirement doesn’t stop the operation.
This has been a guide to commercial credit and its definition. Here we discuss types, examples, and how does it work along with advantages and disadvantages. You may learn more about financing from the following articles –