Overview
Businesses are constantly in need of an influx of funds to fulfil their one goal or to the other. Sometimes they may be planning to purchase machinery while sometimes they may be thinking about adding more staff or expanding their business units in other cities. Among all these, they may sometimes require funding from investors or seek loans from banking institutions. Credit facilities extended by financial institutions allow businesses to satiate their fund-based and non-fund-based needs which may come up at any time.
So, what are fund-based loans?
Fund-based loans are credit facilities offered by financial institutions resulting in the physical transfer of funds from their accounts. It encompasses working capital funding needs such as short-term credit, cash credit, overdrafts, payment against documents, Consortium loans, etc., and more. Businesses typically use fund-based loans to gain faster access to funds for better cash flow management enabling actual capital for business operations.
Financing solutions for your business
Types of Funds-Based Loans
Business Loan
Business loans are a type of fund-based credit where the bank lends a certain amount at a pre-specified rate of interest to be repaid after the end of the tenure. Depending upon the business requirements, fund-based loans fulfill various requirements such as setting up the business, managing operational expenses, distribution, or expanding the business units, based on their requirements. Certain categories of loans have been provided below-
Secured and unsecured loans
Lending institutions offer loans which are offered against any tangible or intangible assets like immovable property, machinery, equipment, stocks, FDs, etc. This allows the lender to cover losses in the event the borrower fails to make timely repayments. On the contrary, some loans do not require any security for repayment but normally come up at a higher rate of interest due to higher risk of default for the lender who cannot acquire any assets or securities if an unsecured creditor makes loan default.
Working Capital Loans & Term Loans
Banks and financial institutions offer working capital loans to manage the daily affairs of a business and term loans to meet specific business project-related requirements. These kinds of loans are secured loans and are generally offered against tangible assets or similar securities. Term loans are usually longer in duration with a fixed tenure for repayment but could be repaid after payment in advance without paying any prepayment charges and typically fulfill large funding requirements.
Cash Credit
Banks and financial institutions also offer cash credit facilities to meet their operational requirements daily. Cash credit facilities allow borrowers access to current account requirements allowing them to withdraw money within specified limits for a pre-agreed tenure. The interest rate is levied on the daily closing balance of the current account rather than the borrowing limit of the business entity.
Overdraft Facilities
Overdraft facilities allow business organizations to borrow funds up to a certain pre-specified limit over and above the existing balance for a specific period in a particular current account in a financial organization. Such credit facilities are secured by collateral such as pledging of deposits, securities, mortgages, or some immovable property assuring the lender of repayment.
Export Finance
Export finance is a financing facility extended by financial institutions catering to export businesses to fulfill their working capital requirements, ensuring the business has adequate liquidity for procuring raw materials, manufacture and export goods. Some of the types of export finance facilities include –
Packing Credit Advances
Packing Credit Advances is a sub-category of export finance focused on extending financial support for business functions related to the manufacture and pre-shipment of products. These loans are secured in nature and are generally offered against pledging the stock of goods or any other assets of the business organization.
Post – Shipment Finance
Post-shipment finance facilitates credit facilities primarily to the exporter entities post the products are shipped to the purchasers. Such credit facilities are provided to fulfil any short-term cash liquidity requirements of a business. To avail of post-shipment credit facilities by the exporters, businesses need to present documents and invoices showing exports being made by the organization.
Hire Purchase Finance
Hire Purchase finance is a credit facility extended by financial organizations allowing them crucial business tools and machinery without the liability to make full payment immediately rather than paying them in installments. The customer will initially pay a certain deposit and the remaining balance and interest are repaid over a certain period. Once the loan is repaid fully, the ownership is transferred to the final customer.
Bill Finance
Also referred to as a Bill of Exchange, a Bill of Finance allows the borrower to make a payment of a specific amount to another party on a pre-determined date with the bill indicating the actual liability of the amount owed monies to the other. As a short-term credit facility, under bill finance, a bank draws a bill of exchange to effectuate a funds transfer from the credit facility offered to the borrower. Some of the different kinds of bill finance include-
Bill Discounting
Bill Discounting enables the seller entity to borrow monies from the lender financial institutions against the monies to be received in the future. As a result, the bank will deduct certain charges from the payment deposited by the borrower entity.
Bill Purchases
Bill Purchase allows the seller entity to seek funds on the basis of certain documents on the sale when not drawn under the Letter of Credit (LOC). The lender institution sends the documents to the purchaser’s bank to receive payments.
Leasing Finance
Lease financing is a well-known long-term financing under which the asset owner grants the other party a limited right to use the asset in exchange for timely repayments in pursuance of a financial contract for a long period. While the owner of assets is known as the lessor, the user is referred to as the lessee. The lessor gets regular payments periodically for allowing use of the assets. At the conclusion of the lease period the lessor may sell the asset to the lessee.
Retail Credit
Retail credit facilities are portfolios of various business debts that could be applied for different business requirements. These facilities offer capital to meet varying needs of a business, whether it be supporting an equity funding plan of a business either with a credit facility and equity investment or both or as various mechanisms for corporate loans, consumer lending, or packaging of credit accounts. Hence, credit facilities could be structured with different kinds of debts including term loans and revolving credit accounts.
What are non-fund-based loans?
As the name suggests, non-fund-based loans are credit facilities where there is no physical transfer of funds to the borrower, rather a promise or assurance made by the bank to honor debt-related obligations in the event the borrowing entity fails to repay loans. Letter of Credit, Letter of Comfort, Bank Guarantee, etc. are some examples of non-fund-based loans.
Non-fund-based loans extend assurance for financial security to the seller, helping businesses stabilize and expand their operations, improve creditworthiness, and foster better business relationships.
Types of Non-funded loans
Letter of Credit
Letters of Credit or LOCs are provided by financial institutions to the seller by the buyer ensuring timely repayments within the due period. LOCs assure repayments within the due date where the actual debtor fails to ensure repayments on time by stepping in to the position of the debtor and later collect the due sum from the buyer along with deducting certain charges. For security purposes, banks also seek collateral from buyers to avoid any losses from the buyer default. LOCs have gained an immense reputation as a significant tool for payments between sellers and buyers in cross-border transactions with different legal jurisdictions. Some of the common types of LOCs are-
Sight Credit
Sight letter of credit assures payment for goods and services. Initially, the debtor makes a request for a sight LC from the issuer bank which is later sent to the seller’s bank. Next, the buyer makes a repayment to the issuer bank-issued sight LC once goods or services have reached the buyer.
Revocable & Irrevocable Credit
Revocable Letter of Credit means LOCs that could be either revoked or canceled by the issuer bank without any obligation to notify the seller or buyer. On the other hand, irrevocable LOCs cannot be revoked or canceled by the issuer bank. Therefore, if irrevocable LOCs are generated, banks cannot deny the obligation to honor the LOC.
Confirmed Credit
Confirmed LOCs are the credit facilities where a bank other than the issuer bank authorizes the Letter of Credit via confirmation. However, only irrevocable LOCs are eligible for confirmation.
Back-to-Back Credits
Under Back-to-Back Credit, the exporter entity makes a request to the banking institution to extend LOC to a local seller based on the export LOC received from a foreign buyer.
Bank Guarantee
A bank guarantee is an assurance of repayment of a debt obligation made by a banking institution in pursuance of a transaction between two parties -customer and beneficiary where the bank agrees to act as a guarantor for repayment in the event the customer defaults on the loan or compensate the beneficiary where it has suffered losses due to non-performance of the terms of the contract. Some of the types of bank guarantees include-
Financial Guarantee
Banks provide financial guarantees to the customer for the protection of the beneficiary against any losses in the event the borrower has failed to honor his debt obligations leading the guarantor to step up and make payment to the beneficiary for the pre-agreed amount.
Performance Guarantee
In pursuance of a contract the borrower and the creditor agree to the performance of certain conditions, however, if the customer to whom the guarantee has been extended fails to perform the terms of the contract to the satisfaction of the beneficiary leading to damage or losses for the beneficiary.
Advance Payment Guarantee
Where the beneficiary demands certain advance money from the borrowing business entity, the issuer bank extends an advance payment guarantee promising a return of advance in the event of failure to the pre-agreed terms.
Deferred Payment Guarantee
This category of guarantee is usually provided on the purchase of tools and machinery by businesses to extend assurance on deferred or postponed repayments.
Letter of Comfort for Availing Buyers’ Credit
A letter of Comfort is essentially a guarantee provided by a banking institution to either the purchaser of goods or the importer. These letters of comfort could be employed to benefit the importer from foreign banks. In exchange for issuing a letter of comfort, the issuer bank levies certain fees or charges.
Buyer Credit
Another short-term funding option available to importers of goods is Buyer’s credit. It allows importers access to loans from global institutions at lower rates of interest helping smooth import business operations. Hence, buyer’s credit allows importer businesses to avail capital for all sorts of capital as well as non-capital goods.
Supplier Credit
Supplier credit enables foreign suppliers or foreign financial institutions to extend credit facilities to the importer on the basis of Libor-linked rates in exchange for LOCs lower in usage LOCs.
Need for Fund-based and non-fund-based loans
- Providing necessary financial support – Lending fund-based credit facilities as well as assurance in the form of non-fund loans helps businesses to grow and expand their reach domestically as well as internationally.
- Financial Stability: Fund-based credit facilities help businesses to function smoothly, and plan their budgets and cash flows accordingly which helps them to stabilize their business and turn financially secure.
- Risk Management- Before sanctioning loans, banking institutions assure themselves regarding the financial health of a business by performing comprehensive due diligence which in turn helps manage risk for them as well as the beneficiary, significantly mitigating risk.
- Supporting Trade: Fund-based as well as non-fund-based businesses ensure business organizations make the most out of the trade which nurtures business growth and economic development.
- Improving Creditworthiness – Non-fund-based business loans boost the creditworthiness of a business with no effect on the cash flow of a business which helps them to access better financing options.
- Reduced Risk: Debt diversification into fund-based and non-fund-based loans also reduces the risk across diverse categories of assets for the business as well as overall risk exposure for the bank.
Take Away
Therefore, fund-based as well as non-fund-based loans are beneficial for businesses allowing them to run their operations seamlessly, expand their business operations, and make smart business choices. Irrespective of whether you are a business owner, investor, or finance professional, it is necessary to hold knowledge regarding their purposes and advantages to be able to comprehend wise strategies to steer the business. A healthy balance between the two could help in efficient financial management as well as achieving financial goals timely.