Management Study

Bank Finance: Form and Security Required in Bank Finance

Bank Finance
Written by punit

Bank borrowing is one of the important sources of finance for companies in the need for funds, especially working capital requirements. Bank borrowing, as a source of short-term finance, ranks just next to `Trade Finance’ which is the most popular mode of short-term finance in India. The amount approved by the bank for a company’s working capital needs is termed as ‘Credit Limit’. The maximum amount of credit, the company may obtain from the entire banking system in India, is referred to as ‘Maximum Permissible Bank Finance’ (MPBF). For seasonal industries, banks are expected to prescribe separate credit limits for ‘Peak Season’ and Non-peak Season’ indicating the period during which such limits would be utilized by the borrower.

Generally, banks do not extend 100% of the credit limit sanctioned by them. An amount is known as ‘Margin Money‘ is deducted from the ‘Credit Limit’. The concept of ‘Margin Money’ is based on the principle of conservatism and is basically in place to ensure security. If the ‘Margin Money’ requirement is 20%, the lending bank would extend borrowing facilities only up to 80% of the value of the asset. This implies that the security of the bank’s lending should be maintained even if the asset’s value falls by 20%.

Forms of Bank Finance

Once the credit limits of the company are sanctioned by the banker, funds can be utilised, within the limits of `Maximum Permissible Bank Finance’, in the following manners:

Banking finance

1) Term Loans:

Term loans are generally granted by banks for a fixed period for the acquisition of fixed assets. The interest rate charged on term loans is linked to the base rate of the bank. The interest rate is also revised, as and when the base rate of the bank is revised. The repayment schedule of the term loan is fixed at the time of the sanction by the bank. The repayment of a loan can be done through Equated Monthly Instalments (EMI) which includes repayment of the ‘partial principal amount’ and ‘interest accrued’ thereon. The borrower has an option to repay the loan through ‘Equated Principal Instalments’ (EPI) also. The primary security made available for a term loan is the asset (s) created out of the loan. On the other hand, the collateral securities may have a charge on one or more of the following:

  • Assets not created out of the loan,
  • ‘Lien’ created on the deposits of the owners of the borrowing company or other third parties, and
  • Fixed Deposits or any other financial instalments like Indira Vikas Patra, Kisan Vikas Patra, NSCs, LIC Policies, etc., deposited with the bank.

2) Cash Credit:

A Cash Credit facility is working capital finance extended by a commercial bank to its borrowers against the primary security of current assets, like inventory, sundry debtors, etc. The primary security may either be hypothecated in favour of the bank or it may be ‘pledged’ with the bank. Cash Credit is availed by the manufacturing units for the purchase of raw materials and by trading units for buying finished goods.

A cash Credit account is a running account, from which money is withdrawn to purchase raw materials or finished goods and sales proceeds are deposited in the Cash Credit account to be again withdrawn for the purchases. This cycle goes on and on. However, the withdrawal of money is restricted to the amount of cash credit limit sanctioned to a particular borrower. Under the cash credit (hypothecation) account, the physical possession of the raw materials or goods remains with the borrower who has to use them for production of finished goods and their selling in the market.

3) Overdrafts:

Under this arrangement, banks allow their esteemed customers to withdraw beyond the balance available in their account. This is extremely useful in cases where the company is suffering from a short-term cash flow problem and does not require a large number of funds on a long-term basis. A borrower in need of such kind of facility may approach his banker and negotiate for an overdraft facility. The bank after satisfying itself with regard to the borrower’s history (of operations in the account and credit-worthiness) may sanction an overdraft limit. Like cash credit limit, overdraft limit is also a revolving facility (i.e., having any fixed period for repayment), which involves overdrawing in the account and its regularisation by depositing money and again overdrawing and regularising the account.

The advantages of overdraft is the facility of drawing extended by a bank ensures availability of cash (within the limit) on tap and the borrower is relieved of the day-to-day worry of managing funds for its business operations. In essence, the cash management functions of a borrower are taken over by its banker. Another advantage of availing overdraft facility from a bank is that the interest calculation, to be charged from the borrower, is done on a daily basis. Therefore, the interest burden on a borrower is only limited to the actual time and amount of borrowing, i.e., the interest accrued on the amount of borrowing and the time period for which the borrower has availed it.

4) Bills Discounting:

Discounting the ‘Bill of Exchange’ is one of the major activities of some of the banks. ‘Bill Discounting’ is a short-term money market instrument which is negotiable and self-liquidating in nature. The process of bill discounting involves the following steps:

  • Drawing of the bill by a bank borrower on its customer by subtracting the commission and its acceptance by the latter,
  • Presenting the bill by the borrower to its banker for discounting,
  • Discounting of the bill and upfront payment to the borrower by the bank,
  • Presentation of the bill by the bank to its borrower’s customer on the due date for collection of the entire amount.

In case of delay in payment by the borrower’s customer, the borrower or his customer is liable to pay interest as per the terms of transaction agreed upon by the bank and its borrower.

Security Required in Bank Finance

Various types of security required in bank finance are as follows:

1) Hypothecation:

The bank, under this type of arrangement, extends the working capital finance to the borrower against the security of assets generally in the form of inventories, viz., RM, WIP, FG, Debtors’ etc. The inventories continue to remain in the borrower’s possession. The borrower keeps the bank informed regarding the inventory level maintained by it in the form of a stock statement which is sent to the bank regularly. The bank calculates the drawing power of the borrower on the basis of the stock statement submitted by the borrower. The bank also has a right to inspect the stock held in this session of the borrower. Banks generally are inclined to emend credit against hypothecation only to its customers having a track record of conducting their accounts.

Also Read:- Meaning, Definition and Functions of Financial Management

2) Pledge:

This arrangement is similar to the ‘Hypothecation’ except the fact that the physical possession of securities under ‘Pledge’ is with the bank which has a right of ‘Lien’ in respect of those securities. In case of default on the part of the borrower, the lending bank has a right, besides suing the borrower, to sell the assets kept with it as a security, after giving due notice in this regard.

3) Mortgage:

It is defined as a legal agreement that transfers the conditional right of ownership of an asset or property by its owner to a lender or bank security for a loan. In this arrangement, the possession of the property may remain with the owner or borrower but the legal documents relating to the property are in the possession of the lender or bank. The owner of the property (transferor/borrower) is called as the `Mortgagee whereas the lender/bank (transferee) is called ‘Mortgagee’. The instrument of transfer is referred to as the ‘Mortgage Deed’.

4) Lien:

It is defined as the creditor’s conditional right of ownership (called security interest) against a debtor’s asset or property that restricts its sale or transfer without paying off the creditor. The lien may be `specific lien’ or ‘general lien’. ‘Specific Lien’ also termed as ‘Particular Lien’ is the lender’s right over a particular property until the claim associated with that property is repaid in full. ‘General Lien’ is the lender’s right to retain the property until all dues of the lender are paid off. Banks, as lenders, generally enjoys and exercises ‘General Lien’.

5) Charge:

If an immovable property of a person (borrower) is kept as a security to ensure payment of dues to another (lender/bank), and such a transaction does not equal to the mortgage, the latter (lender/bank in this case) is said to have a ‘Charge’ on that immovable property. All the provisions of simple mortgage are applicable to such ‘Charge’. Although there are striking similarities between a ‘Mortgage’ and a ‘Charge’, they are distinctly different from each other as may be seen from the following table:

About the author

punit

Professional Blogger, Youtuber, Entrepreneur And Digital Marketer, Founder of Eazzyone

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