Cash Credit against Book Debts - A Discussion

Vinu: Hi Manu, can you help me understand how to assess the Cash Credit or Overdraft limit for a business entity against Book Debts as security?

Manu: Sure, Vinu. Assessing the limit involves a thorough evaluation of the business’s financial health and the quality of the book debts. Let’s break it down step-by-step.

Vinu: That sounds good. What should we consider first?

Manu: First, we need to analyze the financial statements of the business. This includes the balance sheet, profit and loss account, and cash flow statements. We look at the company’s overall financial health, profitability, and cash flow patterns.

Vinu: How do we assess the book debts themselves?

Manu: We evaluate the ageing of receivables. Book debts should ideally be less than 90 days old. The older the debt, the riskier it is. We also look at the diversification of the debtors—a wide base of debtors is less risky than a concentrated one.

Vinu: What about the actual calculation of the limit?

Manu: The limit is typically a percentage of the net book debts, which means gross receivables minus provisions for doubtful debts. Banks usually consider around 75% to 85% of the net book debts as the drawing power.

Vinu: Are there any specific ratios or benchmarks we need to look at?

Manu: Yes, we should consider the Current Ratio (Current Assets/Current Liabilities) to ensure the business has enough short-term assets to cover its short-term liabilities. A ratio of at least 1.33 is desirable. Receivables collection period should be at acceptable levels.

Vinu: What safety precautions should we take?

Manu: It's important to:

Verify the authenticity of the receivables through external auditors.
Ensure there's no concentration risk—the receivables should be spread across multiple customers.
Conduct a periodic review of the account, including frequent inspections and audits.
Monitor the end use of the funds to ensure they are used for business purposes and not diverted.
Take appropriate insurance to cover the receivables.

Vinu: How often should we review these limits?

Manu: Generally, the limits are reviewed annually. However, if there are significant changes in the business’s operations or market conditions, a more frequent review might be necessary.

Vinu: What kind of documentation is required from the business?

Manu: We require detailed receivables statements, financial statements, debtor-wise ageing reports, and sometimes customer confirmations. Additionally, the business must provide regular updates on their receivables position.

Vinu: Thanks, Manu. This clarifies the process and the factors we need to consider. I'll ensure we incorporate these aspects into our assessments.

Manu: You’re welcome, Vinu. Always remember, our goal is to support the business while minimizing our risk exposure. Proper assessment and regular monitoring are key.