Fund/Non-Fund Based Working Capital

Fund-Based Credit Limits

Fund-based credit limits are financial products that a bank or lender will give that allows businesses to physically draw funds out of their accounts.

Fund-based working capital includes funding such as:

Short Term Loans
Cash Credit or Overdrafts
Term Loans for Fixed Assets

Businessman use fund-based credit limits to gain quicker access to cash to help address things like cash flow problems or even stock.

Fund-based Credit Limits refer to a type of financing where financial institutions provide direct monetary assistance to businesses. This direct financial support can take various forms, such as loans, cash credits, overdrafts, and bill discounting. Unlike non-fund-based credit, which involves the bank’s guarantee but no actual movement of funds unless the guarantee is called upon (like letters of credit or bank guarantees), fund-based credit involves the actual disbursement of funds from the lender to the borrower. Here’s a closer look at some of the common types of fund-based credit:

Loans: These are financial transactions where a lender gives money to a borrower, with the agreement that the borrower will return the principal amount along with interest or charges over a specified period.
Cash Credit: This is a short-term source of finance where a business can withdraw money from a bank account up to a certain limit. This is a flexible form of lending that allows businesses to meet their day-to-day operational expenses.
Overdraft: Similar to cash credit, overdraft facilities allow account holders to withdraw money from their accounts even if the account balance falls below zero, up to a specified limit. Interest is charged on the overdrawn amount.
Bill Discounting: This is a financial service in which a bank purchases a bill (promissory note or invoice) before it is due and credits the value of the bill after a discount charge to the customer’s account. It is a way for businesses to get cash immediately for their invoices instead of waiting for the payment term to expire.

Fund-based credit is crucial for businesses, especially for meeting their working capital requirements, financing their expansion plans, or managing cash flow fluctuations. Banks and financial institutions assess various factors like creditworthiness, financial health, collateral offered, and the purpose of the loan before extending fund-based credit facilities to businesses.

Non-fund based credit limits refer to banking services where no funds are immediately disbursed by the bank to the beneficiaries. Unlike fund-based credit, which involves direct financial assistance to the borrowers, non-fund based credit facilities are contingent liabilities for the bank, turning into fund-based credit only upon the occurrence of a certain event. These facilities are primarily used in international and domestic trade and are critical for businesses that require guarantees or letters of credit for their operations. Here are the main types of non-fund based credit limits used in India:

Letters of Credit (LCs): Used primarily in international trade, a letter of credit is a guarantee from a bank that a buyer’s payment to a seller will be received on time and for the correct amount. In case the buyer is unable to make a payment on the purchase, the bank will cover the full or remaining amount owed.
Bank Guarantees (BGs): A bank guarantee is a promise from a bank or a financial institution that if a particular borrower defaults on a loan, the bank will cover the loss. Bank guarantees help companies to make purchases that they would otherwise not be able to afford.
Performance Bonds: These are issued by a bank on behalf of a contractor to provide assurance to the project owner that the contractor will perform in accordance with the terms of the contract. If the contractor fails to perform, the bank pays the project owner a sum of money.
Standby Letters of Credit: Similar to a bank guarantee, this is used as a backup plan in case the client fails to fulfill a contractual commitment with a third party.
Export and Import Financing: This includes various types of non-fund based facilities to support exporters and importers, ensuring that transactions proceed smoothly without the need for immediate payment.

Non-fund based credit limits are significant for businesses as they help in managing liquidity and cash flow efficiently. They provide a safety net for both the buyer and the seller in a transaction, ensuring that obligations will be met even if one party cannot fulfill them directly. This type of credit facility is crucial in facilitating international trade and other large-scale transactions where direct financial transactions may involve significant risk.