Many of the businessmen turn towards Banks to meet their funding needs for working capital requirements. However, they get confused as to what type of working capital instrument would suit them given their personal and professional objectives. The objective of this article is to decipher this confusion and give clarity on the subject matter.
Types of Fund-Based Working Capital
Following are the three most common types of working capital funding instruments that a business borrower can resort to from Banks
1. Cash Credit (CC):
In this case, the bank sanctions a particular amount of credit limit and you are free to use any amount within that limit. Interest is levied only on the amount you utilize (on daily balance basis) and not on the full sanction limit. However, the maximum amount you can use in a particular month is the lower of the two parameters:
a. actual sanction limit or
b. amount derived as per your eligibility in the Drawing Power (DP) statement.
2. Bank Overdraft (OD):
Bank Overdraft is generally given to very small borrowers and works similar to Cash Credit on the same principle. However, one major difference is that the requirement of DP statement is not applicable here and one need not submit any stock statement related information to the Bank on a monthly basis. Here also, you pay interest on the amount utilized on a daily basis.
3. Dropline Overdraft (DOD):
Dropline Overdraft (DOD) is an innovative concept and is introduced by certain banks to cater to the working capital needs of certain sections of the borrower. At times, the borrower wishes to get debt free but knows that this cannot happen overnight – it has to be a gradual and disciplined process. Dropline Overdraft (DOD) comes to the rescue for these types of borrowers. In the case of Dropline Overdraft (DOD), one is free to utilize the working capital funds just like CC / OD and you pay interest only on the amount utilized. However, every month, a fixed amount of the credit limit is gradually reduced so as to ensure that you have discipline to manage your business with a little lower banking limits. Over a period of the next 3-5 years, it is expected that your limit will gradually become zero; you have good discipline to run your business without bank funding and become debt free.
Understanding Cash Credit, Overdraft (OD) and Dropline OD
Difference Between the Different Types of Fund Based Working Capital
A tabular comparison of all three working capital instruments is given hereunder:
| Parameters | Cash Credit | Overdraft | Dropline OD |
|---|---|---|---|
| Credit Limit | Fixed | Fixed | Reduce gradually |
| Purpose | For working capital | Could be for general business purposes | Normally for working capital |
| Credit Limit | Fixed | Fixed | Reduce gradually |
| Interest | Charged at month end on running daily balances | ||
| Interest Rates | Slightly lower than other instruments | Marginally higher than Cash Credit (at times) | |
| Processing Fee | Applicable & paid on the entire sanctioned limit | Paid on the entire limit even though you don’t have that limit for the full year | |
| WCDL sub-limit | Can be given on a case to case basis | Not offered | |
| Drawing Power (DP) Statement | To be submitted every month | Not needed | Normally not required |
| Stock Audit | Required to be done (at borrower’s expense) | Not Required | |
| Collateral Needed | Marginally lower than Overdraft / Dropline OD | Marginally higher than Cash Credit | |
| Repayment of Loan | Ideally, on the bank’s demand; however, the same gets annually renewed and no repayment happens On Demand | Monthly, quarterly, half yearly or yearly | |
| Tenure | 12 months | 12 months | For a longer period |
| Monitoring by Bank | Regularly | Irregular | Partially Done |
| Bank’s Comfort | Very likely – most common product, subject to credit satisfaction | For small loans and depending upon the nature / profile of the borrowers | Mixed (only certain banks) |
Which banking instrument (CC / OD / DOD) is good for you?
Deciding between the Cash Credit, Bank Overdraft and Dropline OD can be a mounting task. The answer to the above depends upon a host of factors.
- Overdraft facility is generally offered by banks only on loans up to Rs. 3-5 crore. For amounts beyond Rs. 5 crore, banks prefer to seriously monitor the borrower’s financial performance rigorously and review stock statements every month. Hence, they shall offer Cash Credit and not Overdraft facility.
- What is your mindset and capability as a borrower? Do you want to become debt free? So, a forced discipline mechanism of Dropline OD would be apt for you. However, in case you think your business will be severely impacted because of the consistent limit reduction every month and you shall not be at ease; then Dropline Overdraft (DOD) is not meant for you.
- Do you have enough resources / bandwidth / systems within your company who shall work tirelessly to provide the DP Statement to the Bank every month? If not, then you may explore availing an Overdraft instead of a CC or simply choose to contact us at BankKeeping.
So, to conclude, all these instruments, Cash Credit, Overdraft and Dropline OD, have their own pros and cons and these have been designed by Banks keeping in mind the different categories of borrowers. So, go ahead and choose the one which is best suited for you. To ensure accuracy in monthly interest debits and to avoid overpaying interest, you may choose to use BankKeeping.
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