Short-Term Finance: Trade Credit and ICD
"Ranchi Handloom Emporium" is a retail outlet that sources exquisite silk sarees from a large-scale manufacturer in Bhagalpur. Every month, the emporium orders stock worth ₹5 Lakhs. Instead of paying cash immediately upon delivery, the manufacturer allows the emporium a period of 45 days to settle the bill. This arrangement is based on the long-standing trust and high creditworthiness of the retailer. The emporium uses this time to sell the sarees to final customers and then uses that cash to pay the manufacturer. This allows the emporium to maintain a high inventory turnover without blocking its own working capital. The owner noted that this facility is available automatically as part of the purchase transaction and requires no formal mortgage of assets. It acts as a continuous source of finance that grows as the business volume increases, making it the most convenient short-term funding method for their daily operations.
Questions:
(a) Identify and explain the source of short-term finance discussed in this case.
(b) State two merits of this source of finance highlighted in the scenario.
(c) Is there any legal charge created on the assets of the emporium for this facility?
(a) Identify and explain the source of short-term finance discussed in this case.
(b) State two merits of this source of finance highlighted in the scenario.
(c) Is there any legal charge created on the assets of the emporium for this facility?
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Answer:
(a) Trade Credit: It is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment.
(b) Merits:
1. Convenience: It is a readily available and spontaneous source of finance that does not require formal negotiations.
2. No Security: It does not require any charge or mortgage on the assets of the firm.
(c) No. Trade credit is typically unsecured and does not involve creating any legal charge on the assets of the buyer.
(a) Trade Credit: It is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment.
(b) Merits:
1. Convenience: It is a readily available and spontaneous source of finance that does not require formal negotiations.
2. No Security: It does not require any charge or mortgage on the assets of the firm.
(c) No. Trade credit is typically unsecured and does not involve creating any legal charge on the assets of the buyer.
"Steel-Tech Ltd," a cash-rich manufacturing company in Jamshedpur, currently has a surplus of ₹80 Lakhs in its bank account which is earning very low interest. Simultaneously, "Ranchi Fabrications Pvt Ltd" is facing a temporary cash crunch and needs ₹50 Lakhs for 90 days to fulfill an urgent export order. Instead of going through the lengthy documentation of a bank loan, "Ranchi Fabrications" approached a financial broker. The broker arranged for "Steel-Tech Ltd" to deposit ₹50 Lakhs directly with "Ranchi Fabrications" at an interest rate higher than the prevailing bank rates. The transaction was completed within two days based on a simple promissory note. The CFO of Steel-Tech noted that while this was a great way to earn a higher return on their idle cash, it was also riskier than a bank deposit because there was no collateral involved. This market for "company-to-company" lending allowed for a quick resolution of short-term financial needs within the corporate sector.
Questions:
(a) Identify the source of finance being utilized by the two companies.
(b) Why did the companies prefer this over a traditional bank loan?
(c) Explain the "Unsecured" nature of this transaction as mentioned in the case.
(a) Identify the source of finance being utilized by the two companies.
(b) Why did the companies prefer this over a traditional bank loan?
(c) Explain the "Unsecured" nature of this transaction as mentioned in the case.
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Answer:
(a) Inter Corporate Deposits (ICD): These are unsecured short-term deposits made by one company with another company.
(b) Preference: It is preferred because it is a quick transaction with minimum documentation and does not require the lengthy formalities and bureaucratic hurdles of a traditional bank loan.
(c) Unsecured Nature: This means the lending company (Steel-Tech) does not have any collateral or security against the funds provided. If the borrower defaults, the lender has no assets to seize, making it a high-risk transaction.
(a) Inter Corporate Deposits (ICD): These are unsecured short-term deposits made by one company with another company.
(b) Preference: It is preferred because it is a quick transaction with minimum documentation and does not require the lengthy formalities and bureaucratic hurdles of a traditional bank loan.
(c) Unsecured Nature: This means the lending company (Steel-Tech) does not have any collateral or security against the funds provided. If the borrower defaults, the lender has no assets to seize, making it a high-risk transaction.
Mr. Mehra runs a construction company and is evaluating his options for raising ₹20 Lakhs for a period of six months. He has two requirements: first, he needs to buy cement and bricks worth ₹10 Lakhs, and second, he needs ₹10 Lakhs in cash to pay overdue electricity bills and office rent. For the construction materials, his regular supplier has offered him credit for 120 days. For the cash requirement, another corporate friend has offered him a 6-month deposit at a 12% interest rate. Mr. Mehra is comparing the two. He realizes that while the supplier's credit is practically free if paid on time, the corporate deposit involves a high interest cost. However, the supplier cannot provide him with the "cash" he needs for the rent. He decides to use both sources simultaneously to manage his obligations. He understands that one source is specifically tied to the movement of "goods," while the other is a "financial" transaction between two corporate entities to bridge a cash deficit.
Questions:
(a) Distinguish between the two sources of finance mentioned in this case.
(b) Which source is specifically used for "financing inventory"?
(c) Mention one risk for the company providing the 6-month deposit.
(a) Distinguish between the two sources of finance mentioned in this case.
(b) Which source is specifically used for "financing inventory"?
(c) Mention one risk for the company providing the 6-month deposit.
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Answer:
(a) Distinction: The first source is Trade Credit, which is tied to the purchase of goods (inventory). The second source is Inter Corporate Deposit (ICD), which is a cash loan between two companies.
(b) Financing Inventory: Trade Credit is specifically used to finance the purchase of inventory/supplies.
(c) Risk: The primary risk for the lender in an ICD is the Risk of Default, as the loan is unsecured and there is no collateral to recover the money if the borrower fails to pay.
(a) Distinction: The first source is Trade Credit, which is tied to the purchase of goods (inventory). The second source is Inter Corporate Deposit (ICD), which is a cash loan between two companies.
(b) Financing Inventory: Trade Credit is specifically used to finance the purchase of inventory/supplies.
(c) Risk: The primary risk for the lender in an ICD is the Risk of Default, as the loan is unsecured and there is no collateral to recover the money if the borrower fails to pay.
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