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Basic Concepts of Credit for Beginners

Balasubramanian 
on 28 November 2012

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Credit – Basic Concepts

We often hear that Business enterprises avails credit facilities in the form of “Cash Credit”  and “Term Loans” from Banking system in order to meet the funding requirements of the business for their day-to-day operations and Capex plans. The basic concepts of the “LOAN” and “MANAGING THE FUND FLOW” remain the same whether it is for an individual or a business enterprise. Let us go through the following to have deeper understanding:-

Assuming a person “X” earns a net salary of Rs.50000/- per month. He incurs family expenses of Rs.40000/- per month in the form of say Rent, Household expenses, Medical expenses, School Fees, Conveyance, Telephone and other Maintenance expenses. The surplus available is Rs.10000/ p.m translating into the annual savings of Rs.1,20,000/- This is nothing but retained profits from his salary savings.

a. In case of “X” incurs additional expenses say during festive seasons or to meet medical expenses to the tune of Rs.20000/- on a particular month - what he will do?

b. In case of “X” wants to purchase Washing Machine, Refrigerator, New television Set etc., to the tune of Rs.50000/- on a particular month – what he will do?

c. In case “X” buys a property beyond his means viz., raising short term finance, loan from private financier? – what will happen?

There are two possibilities in the first case – (a)

· If he utilizes the expenses out of monthly savings, he will not end up in any shortage of cash/funds to meet the additional expenses.

· In case, the surplus is earmarked for some other commitment say Mutual funds or Insurance, he can meet the expenses thro’  a -  “CREDIT CARD” –This is nothing but a working capital facility – This can be paid off in the next 2 months’ surplus or savings from the monthly’ expenses – So long as Mr. X utilizes the Credit Card prudently, he will not have any difficulties in meeting the expenses.

In the second case, there are three possibilities

· Mr. X spends about Rs.30000/- for purchase of the said equipments out of the monthly salary – The eventuality will be, he may end up in not having enough funds to meet the day to day expenses -  (This is nothing but meeting the expenses of Fixed assets out of working capital- To be avoided)

· Mr. X takes consumer loan or employee loan of Rs.50000/- for a period of 24 months from his employer instead of utilizing the major portion of his monthly Salary. – This is the ideal way of meeting the requirement so that he will not face any difficulty in meeting the day-to-day expenses as also the EMI repayment of consumer loan. (Funding by way of term loan to meet the expenses of fixed assets is advisable)

· Mr. X meets the expenses of buying the assets out of monthly savings at the end of 6th month or 12th month (as the case may be), he will not face any difficulties – (he meets the expenses of fixed assets out of retained savings /surplus which is nothing but his Capital funds)

In the third case, Mr. X will have severe financial liquidity problems and mis-managing the funds. Will end up in defaulting the payments towards day-to-day expenses. Ideally, he should not have gone for purchase of property when he does not have adequate repayment capacity. He should have planned his funds in such a way that he meets the requirements by – paying 20% of the amount through savings and 80% by way of long term loans say for 15 years or 20 years

Similarly the above concepts are being practiced in the form of “Cash Credit” and “Term loans” when comes to funding requirements of a business enterprise – be it  partnership firm or proprietary concern or company.  We often hear the case of default by a business enterprise. Reason is the same as explained from the view point of an individual.

a.   Meeting the long term requirements out of working capital facility

b.   Does not have adequate profits /internal accruals to meet the capital expenditure plans.

c.    Acquires property /fixed assets without proper financial tie-up.

The principles of managing the funds remain the same. Basic concepts needs proper understanding before appraising the requirement of a business enterprises. There are other factors which play vital role in ensuring the repayment of loans – Business model, ability of the promoters to run the business in an effective manner and integrity of the promoters.

Can revert in case of any queries concerning the concepts of credit facilities or funding requirements - CA K Balasubramanian,  kb4123@gmail.com




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