What is Commercial Credit?

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Types of Commercial Credit

There are mainly two types:

#1 – Secured

In secured commercial credits, the bank charges collateral to agree with companies. So, if the company fails to make the payment, the bank has the right to liquidate the collateralCollateralCollateralization is derived from the term “collateral,” which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay.read more and use the money to clear the outstanding amount. The credit is secured, so the interest charged is less, and the limit is high.

#2 – Unsecured

Collaterals do not back unsecured commercial credits. So, the credit lineCredit LineA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more is risky. Banks usually charge higher interest rates in this case, and the credit limits are also less.

How Does it Work?

Companies require cash to deal with day-to-day expenses or sudden capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more requirements. So, to avoid a cash crunch, they enter into a commercial credit agreement with banks. A commercial agreement is a privilege provided to companies by banks, where the bank sets a withdrawal limit, which the companies can enjoy. No interest will be charged if the company does not withdraw any money. So, it is a pre-approved loan, but the interest is not charged on the absolute limit. It keeps on revolving. When the company pays back the withdrawn money, the account starts to refill and allows companies to remove it again in the future.

Example of Commercial Credit

XYZ Co. has entered into a commercial credit agreement with a bank with a limit of $1,000,000. Due to the current COVID-19 situation, XYZ Co. is suffering a huge decline in sales. The fixed cost Fixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more of the company is constant. So, to pay the fixed price, XYZ Co. must use its commercial credit and wait for the situation to recover. It is extremely helpful during emergencies.

Advantages

  • It helps companies to meet the urgent requirement of cash. Moreover, that inculcates security in managers’ minds as they know it will not hurt daily operations due to cash requirements.As the interest rate is already fixed, it helps managers avoid taking high-interest loans during emergencies.Suppose there is a limited period discount on any asset the company needs. In that case, the company can use the commercial credit to buy the asset and increase productivity.It helps the company invest in long-term illiquidIlliquidIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment.read more securities to earn more interest. As such, a credit takes care of sudden liquidity requirements, so they will not be required to liquidate illiquid assets. As a result, there is always a liquidity premiumLiquidity PremiumLiquidity premium refers to the extra compensation desired by the investors for holding assets that are either difficult to be converted into cash or tradable in the open market at a fair price.read more in illiquid assets.It helps to create a healthy relationship with the bank. In addition, consistent withdrawals and proper, timely interest payments may enable companies to achieve a high credit rating.

Disadvantages

  • Companies start to think it will protect them from meeting expenses, increasing the expenditure. So grows the risk of lower profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more.If timely payments are not made, the interest burden rises, making it difficult for companies to pay back.Failure in payment may lead to poor credit rating, which will increase the cost of funding for the company.

Conclusion

Commercial credit is a privilege given to companies and should be used cautiously. The money withdrawn is not interest-free, so it should only be used when required. On the other hand, it helps companies to operate optimally as a sudden liquidity requirement does not stop the operation.

This article is a guide to Commercial Credit meaning. Here, we discuss types, commercial credit examples, advantages, disadvantages, and how it works. You may learn more about financing from the following articles: –

  • Credit EnhancementCommercial BankCommercial LoansCommercial Papers