Credit and Sources of Credit: Meaning
Credit is an arrangement between two parties wherein one party receives a certain sum of money or an item of value from another. Usually, credit is in the form of a contract and is given against an agreement to repay the amount after the expiry of a certain period of time. In most cases, institutions, businesses, or individuals offer credit in return for a payment of interest as charges for using money. There are numerous sources of credit in the economy. The prominent ones among them are banks, business loans, overdrafts, invoice and stock finance, credit cards, etc.
Businesses are in regular need of credit as funds are always scarce. For growing businesses, initial capital contributions very quickly fall short of their requirements. And the funding requirements remain for its fixed capital expenditures and to meet its working capital needs. Moreover, it will require funds to expand its business too. Hence, businesses remain on the lookout for additional sources of credit/finances to meet their fund requirements. Similarly, individuals also seek credit for meeting their day-to-day expenditures as well as for funding their education or for, buying a car or a home or a home appliance, etc.
What are the various Sources of Credit?
Let us look at the various sources of credit in detail.
The first source for credit and borrowing that comes to one’s mind is commercial banks. And there are no two opinions that these are the first and best funding sources worldwide. In addition to providing credit to businesses for trade and manufacturing and to various service providers, they also provide credit to individuals in the form of personal loans, student loans, automobile loans, home financing, etc.
Banks are a convenient source of credit as many people already have their accounts with them. So everyone has an existing business relationship with them. Moreover, they also have a rapport with the officials of the banks. But in some cases, bank credit can be expensive as the interest rate may be very high. Also, banks may charge a plethora of charges in the form of bank fees, processing fees, documentation charges, etc.
Financial institutions are dedicated credit companies that work just for disbursing credit. They do not offer other services like accepting deposits, providing safety lockers, etc., that commercial banks do. They generally provide medium to long-term credit. Financial institutions are particularly important when large business houses require substantial credit to fund their capital expenditure plans or modernization plans, and that too for a long period of time, ranging for several years. Since these institutions are specialized in providing credit, they also provide financial and technical advice as well as consultancy services.
Financial institutions are an effective form of credit source, especially when the requirement is big and for the long term. But their credit granting criteria are generally very rigid. Also, they may appoint their nominees on the company’s Board of Directors that is taking credit as the sum involved is huge. Hence, this may hinder the powers of the Company’s board. Also, they may monitor the activities of the borrowing company, which may sometimes prove restrictive.
Trade credit is a source of credit that comes along with the day-to-day operations of a business. In trade credit, a business buys goods or services from a seller on credit and agrees to make its payment after a few days. The amount of purchases on credit is credited to the Seller’s account under the head of “Sundry Creditors” on the liabilities side of the balance sheet. It is a form of short-term credit and is given on the basis of goodwill and the market reputation of the buyer. Past business frequency and amount, payment pattern, degree of competition in the market, etc., also affect the amount of trade credit.
The main advantage of such a form of credit is that it is generally interest-free. Hence, the buyer does not have to incur any additional cost to avail of trade credit. Also, it is readily available without any formalities and lengthy documentation. It comes without any charge on the assets of the firm and comes in handy in case of sudden big supply orders. The problem with trade credit is that it depends on the will of the supplier of goods. He may deny giving goods and services on credit at the last moment, which may be a major setback to the buyer. Also, it is a limited short-term arrangement of funds and not a permanent source of credit. Of course, for a running and growing business eventually, it becomes a permanent interest-free source. And as the quantum and time pass, this facility grows for the business too.
Credit cards are a very common source of credit. The card-issuing bank or company pays the seller on behalf of the buyer. The credit cardholder has to then return this amount within a specific period of time. The cardholder has an option to withdraw cash too against his credit card, of course with some interest. This credit arrangement is for the short-term and for small amounts within the credit limit of the cardholder.
Credit cards are easy to use, simple, and do not require much documentation. Moreover, credit cards are an instant source of credit at the time of purchase of any product or service, and no documentation is needed. The flipside of such credit is that it is one of the most expensive forms of credit if the borrower misses the deadline to pay. Interest charges are exorbitant, often around 25%-30% per annum, and the issuer may charge hefty amounts instead of late payment charges when we miss a due payment.
Public deposits are a source of credit directly from the general public. The public can give a company a certain sum of money for a specific time period against the payment of interest. Since these deposits have to compete with the banks and government deposits, hence, the deposits have to provide a comparatively higher rate of interest. It is a small-to-medium term credit option.
The cost of borrowing through public deposits is usually lower than that of borrowing through banks. Further, these are unsecured. Hence, No charge is needed on the assets of the company. The issuing process is simple, the depositors do not get control of the company in any form, and they do not get any preferential or voting rights. Even they remain unsecured creditors in case of winding up of the company.
But only companies with a good track record and goodwill in the market are able to garner funds through such deposits. Also, this source of credit is unreliable. Companies may not be able to get funds in times of urgent need or an emergency. Further, these are short-term sources as the period of the deposit normally remains short, 1-3 years, and the depositor has the right to ask for premature withdrawal.
Commercial paper is a money market instrument and a short-term credit source. Usually, companies issue commercial paper to other businesses, insurance and financial companies, and banks. The amount that can be taken on credit through this route is large, and hence companies with a good reputation and goodwill are only able to issue commercial papers.
Commercial papers are freely transferable, and the process of issuing them is simple without much documentation. But the interest rate on such papers is quite high and more than what banks and other institutions charge. Also, it is a short-term source of credit, and increasing the maturity time is not possible. Such credit is mostly unsecured and can be a problem if the issuer defaults on payments. All these papers usually have a credit rating from the agencies.
Companies issue debentures as a long-term source of credit. It is an acknowledgment that the company has taken a loan from the holder at a fixed rate of interest, and the company agrees to repay back the loan after a fixed period of time.
Companies know in advance what the cost of such credit is as the rate of interest is fixed. Also, the debenture-holders do not have any participation in the company’s profits or its working. The interest that the company pays on debentures is eligible for a tax deduction. Hence, it is a good source of credit for companies with stable earnings. But sometimes debentures can be a burden on the finances of the company too. The company has to make regular interest payments on them. Also, redeemable debentures can be presented anytime for redemption. The company has to allocate and block certain funds to meet the sudden redemption requests.
Moreover, these debentures can be secured as well as unsecured ones. Secured debentures will have a charge on certain assets of the company. The companies may sometimes even appoint debenture trustees for the benefit of debenture holders when a large amount is involved.
Companies can raise a credit against their outstanding invoice value that is due from customers. Companies usually have a long credit period while doing business, sometimes a couple of months or even more. Therefore, they can raise a credit on such outstanding invoices and improve their cash flows. The company that does such financing pays a major part of the money upfront and balances after receiving it from the customers. The Outstanding collection from the debtors becomes the duty of such financiers/credit providers. They get a finance charge in return for their services.
Such credit is only possible with companies that are financially very strong, and there is a surety that their debtors will pay back all the outstanding amounts. Also, the financials and books of accounts should be up-to-date and accurate.
Startup finance is another form of credit available to new businesses. New businesses have their special needs of funds as they are unaware of various types of business costs. They require a continuous inflow of funds for meeting their operational costs, capital expenditure costs, etc.
The eligibility criteria for such loans are very stringent as the company is new. Also, there is a need for strong collateral to get such a form of credit from banks and other financial institutions. However, governments keep coming up with promotional plans to encourage startups and may provide such credit with limited formalities and collateral security. In the present circumstances, there are various other sources like angel investors, VC financing, crowdfunding, etc., are available for new start-ups.