Money is a crucial aspect in an individual’s life as well as for the business that are run by various companies. It is difficult to function without funds to face the competition in the market. Organizations and companies need funds to procure raw material for production, administrative services, capital, etc. These companies being competitive in nature are frequently investing to facilitate better products and services in comparison to others. On the other hand, individuals on a daily basis also require a supply of funds so as to meet their various requirements and live a hassle-free life. Apparently, neither the companies nor an individual is financially equipped with unlimited funds and thus loans and advances come into play and fill up the deficit in funds.
To obtain the loans and advances, one has to approach the banks or financial institutions. Lending is one of the oldest and most important functions of banks. Accepting deposits and advancing loans is a regular activity of the banks. The deposits accepted from the public by the banks are used to create loans and advances. The banks take necessary precautions while lending money so as to ensure the repayment of the money advanced and honor cheques issued by customers. Loans and advances are one of the best and popular strategy in financing the business.
Meaning of Advances
‘Advance’ is a credit facility granted by the banks to a business entity or an individual to meet their short term financial requirement. These advances are to be repaid within a short period of time for instance one year. The terms of the repayment may vary depending upon the agreement between the lender and the borrower. In India, the terms, conditions and norms of these advances are governed and approved by the Reserve Bank of India and by the plans of the particular bank. As advances are facilitated to fulfill the daily needs or requirements of the companies or an individual, so the banks or financial institutions charge low-interest-rate making it convenient and cost-effective. Very low legal formalities are required to arrange for finances by advances as compared to the procedure of loans. Advances granted to business entities or individuals composed of smaller amounts that are utilized for immediate and short – term objectives.
The advances are granted against securities which are as follows:-
- Primary Securities: Hypothecation of debtors, Promissory notes, etc
- Collateral Securities: Mortgage of property (land, buildings, etc), other fixed assets like machines, etc
- Guarantees: Given by partners, directors or promoters, etc.
Different forms of banker’s advances
1. Cash Credit
Cash credit is the method of lending money by banks to the customers where in the customers can borrow against the security of tangible assets and guarantees up to certain limit specified by the banker, known as ‘cash credit limit’.
This system of cash credit is flexible because it allows the customer to borrow money as and when required according to his needs subject to the limit sanctioned. The arrangement of this system is permanent in nature so the customer does not have to withdraw the entire amount at once.
The bank may renew the limit of the cash credit by the end of the year if it deems the account of the customer to be running satisfactorily. Generally, cash credit is granted to the borrower against the security by way of pledge or hypothecation of tangible securities. This system of cash credit also facilitates funds against personal security.
Interest is charged to the customer only on the amount utilized by him and not for the entire amount. A commitment charge can also be imposed by the bank if the customer does not use the cash limit to the foil extent i.e. only the unutilized amount of the cash credit. The borrower can deposit the surplus funds in the banks which might result in reduced interest charge.
Overdraft is a facility provided to a current account holder by the bank permitting to withdraw over and above the credit balance in the account. This facility is provided for a shorter period of time. With the overdraft facility, a customer is allowed to withdraw money as and when required provided that the total withdrawn amount does not exceed the agreed limit and the customer can also repay in the form of deposits at any point of time as per his convenience.
The interest is charged only on the exact amount withdrawn by the customer from his account and for the period of its actual utilization. A provision of a temporary overdraft facility is also available. Interest charged on temporary overdrafts is imposed as and when the temporary overdraft is adjusted or at the end of the month, whichever is earlier.
Overdrafts are generally granted against the security of government securities, shares & debentures, National Savings Certificates, LIC policies, bank’s own deposits etc. and also on unsecured basis. However regular overdraft limits are sanctioned against some securities. Some collateral security may be taken by the bank and the bank might also grant advances against personal security of the borrower.
The customer has to provide the bank with a written application or promissory note signed by him to avail the overdraft facility. The overdraft facility is usually an agreement of an expressed contract but in the absence of the express contract, overdraft facility can be granted by referring to the course of the business of the borrower. Thus it becomes necessary for the banks to obtain a letter and a promissory note incorporating the terms and conditions as well as the interest chargeable in respect of the overdraft facility.
3. Discounting of Bills
Bill of exchange is an instrument in writing containing of an unconditional order signed by the creditor, directing the debtor to pay a certain sum of money on maturity. Now, under the mechanism of discounting bills, the seller of goods draws a bill of exchange on the buyer as per the terms of the goods supplied.
When the buyer does not have enough funds to buy goods then he takes helps from the bank, the bank then releases funds at a discounted rate to the seller before the credit period ends. This bill is then presented to the seller’s client i.e. the buyer by the bank and the bank recovers the total amount of the goods from the buyer before the credit period matures.
The discount on the bill of exchange depends upon the remaining time to maturity and the amount involved in it. The time period of the credit mostly depends upon the buyer’s creditworthiness. When the buyer buys goods from the seller then the payment is to be made through letter of credit.
In the mechanism of bill discounting, all the three parties i.e. the seller, buyer and banker have advantages and benefit profits. Firstly the seller gets money in advance for his working capital, secondly, the buyer gets a credit period against the letter of credit and thirdly the bank also earns some revenue.
Example – A is a car manufacturer and needs tyres for the manufacturing of his cars. B is a tyre manufacturer. A has been assigned with a project costing Rs 1 lakh to manufacture cars but A does not have enough funds to buy the tyres for the cars. Thus A goes to the bank for help and the bank pays a discounted rate of Rs 95,000 to B provided that A repays the whole amount to the bank within 3 months. After 3 months as A was in a good financial position, he paid the entire amount to the bank and hence the business ran smoothly.
The loan is the money borrowed from the bank on the condition that it is to be repaid in installments or all at once (lump-sum) on the agreed dates and at an agreed rate of interest. The bank charges interest on the entire amount whether or not the borrower withdraws the money from his account or not.
The loan can be obtained with or without security. If the borrower wants loan further too then he has to apply for a fresh loan. Each bank has its own procedure of granting loans and the banks shall have the authority to accept or refuse the loan depending upon its own cash position and lending facility.
Types of loans
I. Demand Loan
Demand loans are the loans which are repayable on demand by the banks. The banks at any point of time can ask the borrower to repay the money with the required interest rate borrowed from the bank. This kind of loan is usually considered short term finance and have no fixed tenures. Demand loans are beneficial for start-up businesses, to fulfill daily and temporary working capital requirements, purchasing raw material and small assets, etc.
ii. Term Loan
Terms loans are medium to long term loans. Term loans are usually granted for longer period of time and have to be repaid within a definite time frame. The repayment tenure of such loans is also longer. In case of business loans, the repayment period of time is usually between 12 months to 60 months. Term loans can be granted on the basis of both fixed and floating rate of interest. When it comes to grant personal loan or home loan then the repayment tenure is 10 years or more depending upon the loan amount and rate of interest.
With the rapid growth and development of the world, the needs and requirements of an individual or companies keep on increasing. To meet such needs, one has to take help to avail funds for their progress. Banks play a vital role in such conditions and thus the world economy is dependent on the banking sector. The different forms of advances provided by the banks have made life easy for the entrepreneurs to start their business and also for the established businessmen who are in constant need of funds for their working capital.
- A study on loans and advances, State Bank of India
- Banking and law practices, The Institute of Company Secretaries of India
This article is Authored by Rutuja Dhotre, 4th Year B.A.LL.B Student at ILS Law College, Pune
Also Read – Process of Credit Creation by Commercial Banks