Cash Credit vs Overdraft: What is the difference?
Created on 11 May 2022
Wraps up in 5 Min
Read by 1.7k people
Updated on 10 Sep 2022
Both are cages. One gold-plated, another regular.
So this is how it starts. You have an idea for your business, a real multi-million dollar one. You are excited, ready to put inhuman hours and struggle to make it succeed. Your friends and family are totally with you. You potentially have a vast customer base. Nothing is going to stop you from establishing the next unicorn. You have all you need except one thing. And your business will fail in the absence of that one tangible factor: CAPITAL.
Let's face it: of course, you will put your own money into the business, and you may secure quasi capital also, but before your business becomes large enough to attract angel funding, you need debt to scale your business. And at this stage of your business, you have two options: Cash Credit and Current Account Overdraft. Let's see the instruments closely.
Cash Credit Account
Cash Credit is a short-term loan specifically designed to help small and medium-scale businesses during a liquidity crunch. Also called a Working Capital Loan, the typical duration for a Cash Credit account is 12 or fewer months. The interest rate is lower than overdrafts. The interest is charged on the utilised limit of the daily closing balance and not on the sanctioned limit.
For example, for a cash credit account, if the sanctioned limit is rupees one lakh and on one day, the maximum daily closing balance is rupees fifty thousand; then for that day, interest will be charged on a maximum of fifty thousand rupees. And not on one lakh rupees. There can be an under-utilisation clause in the agreement, where the interest can be charged if the limit is not utilised up to a specific limit. For example, if the set limit is 30% and you use less than thirty thousand for a month, you will be charged a penalty. This interest rate is considerably lower than the cash credit interest rate.
Cash credit loans are a line of credit that can be utilised based on the need. It is given against collaterals. Hence it is secure. The collaterals can be stocks and receivables and can also be immovable properties, machinery, personal guarantees of the promoters, etc. Banks and financial institutions appraise the performance of the business by evaluating past financial statements and future projections. The gap in working capital, which is current assets minus current liabilities, is calculated, and on that basis, Working Capital Loan is sanctioned to bridge the gap. The cash credit loan can further be divided into Key Cash Credit (KCC) and Open Cash Credit (OCC).
Key Cash Credit:
The main difference between KCC and OCC is how charges can be made on primary collaterals. For KCC, the owner locks the stock in the godown and hands over the key to the bank. As and when the customer remits some money to the financial institution, stock of the equivalent amount can be released from the godown. Depending on the customer's drawing power, an additional amount can be released from the bank if equivalent stock is loaded in the godown.
Open Cash Credit:
Here, the stock or the key is not given to the lender. The borrower is free to use the hypothecated stock at his discretion. The terms and conditions of the loan are governed under an agreement called a hypothecation deed. Normally raw materials, work-in-progress goods, finished goods, etc., are hypothecated under OCC.
There are similarities and differences between a working capital loan and overdraft accounts. Like Working capital loans, overdrafts can have a limit to which money can be withdrawn. Here, no new loan account is created. OD is a short form of overdraft, where a limit is given on an existing current (or savings) account. Here, money can be withdrawn even when there is no fund in the account. The account can go to a negative balance that the financial institute or bank authorises. The approved limit of the overdraft is sanctioned based on the borrower's relationship with the lender. The creditworthiness of the borrower also plays a vital part in it. Here too, the bank only charges an interest rate on the limit utilised till the day's end and not on the total sanctioned limit.
For secure overdraft, some collateral is required. For example, a fixed deposit of one lakh rupees can be kept in the bank for a limit of one lakh rupees. It works as security while the customer keeps on earning interest on the fixed deposit. In case of default, the financial institution can liquidate the fixed deposit account.
For clean overdraft, as the name suggests, no security is needed. It is a kind of unsecured loan. It is given based on the relationship between borrower and lender only.
Difference between Cash Credit and Overdraft
Although there are similarities between cash credit and overdraft, there are many differences between these two financial instruments. Let's discuss some of the major differences.
- Tenure: Working Capital Loan, aka Cash Credit loan, is a short-term loan, generally for one year.
An overdraft facility is generally a long-term credit facility.
- End-use: Cash Credit loan is given to meet the working capital requirements of a business. An overdraft facility can be provided for personal and business use, to be used for any purpose.
- Account: For cash credit loans, a new loan account is created. That might be subsequently renewed over time. For overdraft, the limit is sanctioned on existing savings or current accounts.
- Interest Rate: The interest rate of a cash credit account is relatively lower than that of an overdraft account.
- Collaterals: Stocks and receivables are the primary security for cash credit loans. It can further be secured by fixed assets, machinery, personal guarantee of promoters, etc. For overdraft accounts, primary security is deposits and financial statements.
- Maximum Allowed Limit: The maximum allowed limit for a cash credit account is calculated based on sales and stock figures. A certain percentage of working capital need has to be matched by the own fund of promoters, and only the rest of the amount is given as a working capital loan. For overdraft loans, it is calculated based on financials and security amount.
Any small or mid-sized businesses need loans to scale up their business. However, there are some critical points that they must keep in mind. The underutilisation charge, as discussed above, and account-closing charge can be very high for banks and financial institutions. You must keep that in mind before considering moving your CC or OD account to another lender. There can also be account-opening charges, but you can negotiate with the lender about the same. Also, you can avail of other credit facilities like a letter of credit (LOC), bank guarantee, and Line of Credit from the financial institutes. Once you have started a transaction by cash credit or overdraft and your track record is good, these additional credit facilities can help your business further. Please remember that your performance on these two loans will also impact your CIBIL score. It will hinder or facilitate your future loan application or interest rates further.