The difference between cash credit and trade credit is fundamental to understanding business financing. Both are essential sources of working capital, but the purposes, mechanisms, and applications differ. Cash credit is borrowed from banks or financial institutions, whereas trade credit is a short-term facility given by a supplier. This paper will consider the definitions, features, and distinguishing differences between the two forms of credit, which can help businesses determine the right one for their needs.
What is Cash Credit?
Cash credit is a type of short-term loan provided by banks or financial institutions to businesses. It allows companies to withdraw funds up to a predefined limit, even if their account balance is zero. Cash credit is primarily used to finance day-to-day operational expenses and maintain liquidity.
Key Features of Cash Credit
Cash credit is a short-term borrowing facility provided by banks to help businesses manage their working capital needs effectively. It offers flexibility and revolves around a pre-approved credit limit.
- Bank Financing: Banks provide cash credit against collateral like inventory, receivables, or fixed assets, ensuring security for the borrowed amount.
- Interest on Utilized Amount: Borrowers pay interest only on the amount withdrawn, not on the entire credit limit, reducing overall financial costs.
- Revolving Credit: This facility allows businesses to withdraw and repay funds multiple times within the credit limit, ensuring financial flexibility.
- Renewable Facility: Cash credit limits are reviewed annually and can be renewed based on the borrower’s financial health, aligning with their current needs.
What is Trade Credit?
Trade credit is a short-term credit facility extended by suppliers to buyers, allowing them to purchase goods or services on account and defer payment to a later date. It is a cost-effective method for businesses to manage short-term working capital needs without requiring cash upfront.
Key Features of Trade Credit
Trade credit is a form of short-term financing extended by suppliers to buyers, allowing them to purchase goods or services on credit. It relies on trust and established business relationships, offering flexibility for managing cash flow.
- Supplier Financing: Suppliers provide trade credit to customers based on mutual trust, without involving financial institutions, making it a direct financing method.
- Payment Terms: Trade credit agreements define payment terms, including due dates, discounts for early payments, and penalties for late payments, ensuring clarity and compliance.
- No Collateral Required: Unlike other credit types, trade credit does not require collateral, as it depends solely on the buyer’s creditworthiness and trust.
- Common in B2B Transactions: Trade credit is widely used in business-to-business dealings, particularly in industries like retail, manufacturing, and wholesale trade, to streamline transactions.
Difference Between Cash Credit & Trade Credit
The cash credit vs trade credit comparison reveals their unique roles in business financing. Below are five key differences:
Source of Credit
- Cash Credit: Cash credit is a facility provided by banks or financial institutions to meet the short-term financial needs of businesses. It is specifically designed to help businesses maintain liquidity and manage their working capital effectively.
- Trade Credit: Trade credit, on the other hand, is extended by suppliers to buyers, allowing them to purchase goods or services on credit. It is a form of credit based on trust and the business relationship between the two parties.
Collateral
- Cash Credit: Cash credit requires borrowers to pledge collateral such as inventory, receivables, or other assets. This collateral acts as security for the borrowed amount, ensuring the lender’s risk is minimized.
- Trade Credit: Trade credit does not require collateral, as it is granted based on mutual trust and the reputation of the buyer. This makes it a more accessible option for businesses without significant assets to offer as security.
Interest
- Cash Credit: Cash credit incurs interest charges on the amount utilized by the borrower. The interest rate is determined by the lender and is applied throughout the usage period.
- Trade Credit: Trade credit is usually interest-free for the duration of the agreed credit period. However, suppliers may impose penalties or additional charges if the buyer delays payment beyond the stipulated timeframe.
Purpose
- Cash Credit: The purpose of cash credit is to provide businesses with the liquidity needed to manage operational expenses and maintain smooth functioning. It serves as a financial cushion for meeting short-term requirements.
- Trade Credit: Trade credit is primarily aimed at facilitating the purchase of goods or services. It enables buyers to defer payment, ensuring they can manage their cash flow without immediate financial strain.
Documentation
- Cash Credit: Cash credit requires formal documentation, including agreements, approvals, and detailed paperwork mandated by banks or financial institutions. This ensures the lender’s interests are protected.
- Trade Credit: Trade credit involves minimal documentation, typically limited to trade invoices and mutually agreed terms. It is a simpler and more flexible arrangement compared to cash credit.
| Aspect | Cash Credit | Trade Credit |
| Source of Credit | Provided by banks or financial institutions. | Extended by suppliers to buyers. |
| Collateral | Requires collateral such as inventory or receivables. | No collateral is required; based on trust. |
| Interest | Interest is charged on the utilized amount. | Typically interest-free, but late payments may incur penalties. |
| Purpose | Used for operational liquidity and working capital. | Facilitates the purchase of goods and services. |
| Documentation | Requires formal agreements and approvals. | Based on trade invoices and mutual terms. |
Conclusion
The difference between cash credit and trade credit lies in their source, purpose, and cost structure. Cash credit provides immediate liquidity from the banking sector, whereas trade credit enables businesses to buy goods and pay afterward. Both are important tools for maintaining smooth operations and working capital management. Understanding their distinct characteristics and uses can help businesses make wise decisions to optimize their financial health and growth.
Cash Credit vs Trade Credit FAQs
What is the difference between cash credit and trade credit?
Cash credit is a loan from banks, while trade credit is a payment deferral facility by suppliers.
Is trade credit free of interest?
Yes, trade credit is mostly free of interest but attracts penalties for late payments.
Can small businesses avail cash credit?
Yes, cash credit can be applied for by small business enterprises if they satisfy the eligibility criteria from the bank.
What is the method of calculating interest charged on cash credit?
Interest is charged only on the amount withdrawn, not on the total credit limit.
What is more beneficial for buying commodities-cash credit or trade credit?
Trade credit is more beneficial for buying goods, and that is because there is a deferred payment without interest costs.
