This article throws light upon the top four types of short-term debts. The types are: 1. Commercial Banks 2. Credit Supplies 3. Commercial Paper 4. Short Term Deposits.
Commercial Banks are the largest source of short-term finance. The borrowings are mainly to meet the requirements for working capital as liquid money is locked in Debtors for credit sales, inventories including raw materials, WIP and finished goods as required in normal production process/business as reduced by the ‘credit’ enjoyed for credit purchases.
The working capital is thus represented by the excess of current assets over the current liabilities, when the detailed project report is appraised and approved by the FI, a simultaneous arrangement is also made with the banker, who agrees (under the influence of the FI sanctioning the term-loan for the project) to provide the necessary fund for working capital.
All the fixed assets are mortgaged with the FI providing the term-loan and hence the bank provides the loan for working capital hypothecating the current assets in favour of the bank and such charges are filed with the Registrar of Companies.
As it is unlikely to recover 100% of the cost/value of the current assets by selling them in the market if such need arises, the prescribed rule is to finance 75% of the total amount of current assets, less 100% of the total current liabilities.
The project organisation is to provide every month the return of its accounts including the details of the current assets and the bank—considering the large amount of money involved in such lending—places its representative as non-executive director in the project organisation.
The balance 25% of the current assets is called the ‘margin money’, which is considered as a component of the total ‘project cost’ followed by a detailed calculation of the ‘margin money’ in the project report which is also scrutinised by the FI agreeing for the term loan assistance for the project.
At the time of negotiation with the bank the requirements are projected and then specified with an upper limit of the following components:
1. Cash requirement;
2. Letter of credit facilities;
3. Guarantee facilities.
Supplies at credit are also a source of short-term financing. Depending upon the creditworthiness of the project organisation the suppliers deliver the required materials to the organisation. The terms of credit vary from 30 days to 90 days and the supplies include raw materials and others consumables.
Some of such suppliers arrange payments for credit supplies through bank under Bill Marketing Scheme whereby the bank realises the payment of credit invoices from the project organisation on expiry at the agreed credit period.
Commercial paper is a source of short-term financing in the form of an unsecured promissory note issued by the borrowing companies. The denomination of commercial paper is in multiples of Rs. 5 lakhs and a minimum amount of borrowing (individually) of Rs. 25 lakhs. The maturity period is within the range of 90 days and 180 days.
The basic advantage is matching of short-term cash surplus of the investor with the short-term requirement of fund by the borrower, which should be an well-established organization, whose shares are listed on the stock exchange, and has a minimum credit rating from an approved credit rating organisation.
After an euphoria following the busy season credit policy, activities in the Commercial Paper (CP) market have deteriorated due to reasons including the feeling of uncertainty regarding the future call money rates. While the rates were sky high in the past, they were hovering around four per cent towards the beginning of 1997.
Such low rates give the banks opportunity of committing arbitrage by borrowing funds from the call money market and lending it to corporate in the CP market at around 12 per cent (as prevailing in early 1997).
Short-term corporate financing, outside the arena of banks, is carried out by interoperate deposits (ICD).
The main features are:
1. The lender and the borrower—both are usually companies with standing reputation whereby short-term surpluses of the lender are effectively useful by the short-term need of the borrower;
2. The period of the loan is mostly between 90 days to 180 days.
3. The transaction is carried out very fast which can even be within two days;
4. The document used is in the form of a demand promissory note (DPN);
5. Each transaction usually involves a significant amount of Rs. 50 lakhs to Rs. 1 crore.
6. The security is usually in the form of post-dated cheques (PDC), the bouncing of cheques being made a criminal offence under the Negotiable Instruments Act.
B. Public deposits:
Unsecured loans and deposits are received by the project promoters, friends, and associates including directors who deposit money with the project organisation for short-term and even without interest. Public Deposits, which are mostly for fixed terms, are usually accepted by Non-Banking Financial Companies (NBFC) and Miscellaneous Non-Banking Companies.
The maturity period of such deposits and the schemes about payments of interest vary. The payment of interest can be monthly, quarterly, half-yearly and yearly when interest warrants are despatched for one fiscal year. Deposits are also received under cumulative scheme where the interest is compounded even at monthly rates and principal, together with the accumulated interest, are repaid on maturity.
The maturity period of the deposits is normally as per the requirement periods and the company may reserve the right to repay the deposits even before the maturity period.
In such events the rate of interest will be calculated in accordance with the provisions of NBFC (Reserve Bank) Directions which, as on August 1995, were as follows:
1. Before the expiry of six months – no interest
2. After six months but before the expiry of twelve months – 10% p.a.
3. After the expiry of twelve months but before the date of maturity – 1% less than the contracted rate
The Reserve Bank of India has subsequently relaxed the restrictions imposed earlier on the rate of interest as the NBFCs have been given freedom to fix interest rates on fixed deposits. This relaxation has resulted in offers to the public for deposits at a very high rate of interest, extending to about 28 per cent for a five year fixed deposit (when compounded annually).
The other special feature for such public deposit is the granting of loan facility to the investor up to the extent of 75 per cent of his deposit at an interest rate of two per cent over the contracted rate. Thus, a fixed deposit of Rs 1,000 at 18 per cent can generate a loan facility of Rs. 750 at 20 per cent.
The interest is paid by post-dated cheques and can be quarterly, half-yearly or yearly as opted by the depositor. No income tax is deducted for interest up to Rs. 2,500 and when it exceeds Rs. 2,500 in any year, the depositor may submit application in a form specified by Income Tax Regulation for exemption of tax deduction at source.
As the Public Deposits are received by companies primarily with the idea of meeting the working capital requirements, such public deposits are often called short-term debts, even though the maturity period may exceed 12 months.