Types of Instruments of Credit
Instruments of credit are financial instruments and credit arrangements that facilitate trade, payments, and financing. In addition to Bills of Exchange, several other instruments are used by businesses and individuals to obtain credit, guarantee payments, manage cash flow, and meet financing requirements.
Different instruments of credit serve different purposes. Some contain a promise to pay money in the future, while others provide a bank guarantee of payment. Certain instruments provide short-term finance, whereas others allow borrowers to use credit repeatedly within an approved limit. Important instruments of credit include Promissory Notes, Banker’s Acceptances, Letters of Credit, Trade Credit, Commercial Paper, Factoring, Forfaiting, Installment Credit, and Revolving Credit.
Promissory Note
A Promissory Note is a written promise made by one party to pay a specified sum of money to another party either on a designated future date or on demand. The person who makes or issues the promise is known as the Maker or Issuer, while the person entitled to receive the amount is known as the Payee or Holder.
Unlike a Bill of Exchange, which initially involves a Drawer, Drawee, and Payee, a Promissory Note generally involves only two parties—the Issuer and the Payee. The Issuer directly promises to make payment to the Payee.
Promissory Notes are commonly used in loan agreements and other credit transactions. They provide written evidence of the obligation of the Issuer to repay the specified amount according to the agreed terms.
Key Elements of a Promissory Note
A Promissory Note generally contains the date of issuance, amount of the note, due date or terms of repayment, interest rate if applicable, and signatures of the parties.
These details identify the payment obligation and specify the terms according to which the amount is to be repaid.
For examination purposes, the important distinction is:
Bill of Exchange → Written order to pay
Promissory Note → Written promise to pay
Banker’s Acceptance
A Banker’s Acceptance is a time draft drawn on and accepted by a bank. The acceptance by the bank provides a guarantee of payment.
It is commonly used in international trade to facilitate financing and payment arrangements. When a bank accepts the time draft, the bank provides assurance regarding payment according to the terms of the instrument.
Banker’s Acceptances may also be sold in the secondary market before maturity. This provides liquidity to the holder because the holder does not necessarily have to wait until the maturity date to obtain funds.
Thus, a Banker’s Acceptance combines a time draft with the payment assurance arising from acceptance by a bank.
Letter of Credit
A Letter of Credit or LC is a financial instrument issued by a bank on behalf of a buyer to guarantee payment to a seller for goods or services.
The buyer on whose behalf the Letter of Credit is issued is known as the Applicant, while the seller entitled to receive payment is known as the Beneficiary.
Under a Letter of Credit, the bank undertakes to make payment when the specified documents are presented and the terms of the Letter of Credit are fulfilled.
The important parties are:
Buyer → Applicant
Seller → Beneficiary
Bank → Issuer of the Letter of Credit and undertakes payment according to the LC terms
The Letter of Credit provides payment assurance to the seller. Once the specified terms are met and the required documents are presented, the bank makes payment according to the conditions of the LC.
Letters of Credit are widely used in international trade.
Trade Credit
Trade Credit is a credit arrangement under which a seller allows a buyer to delay payment for goods or services received.
Instead of requiring immediate payment, the seller extends credit terms to the buyer. The buyer receives the goods or services and makes payment at a later date according to the agreed credit terms.
Trade Credit is generally granted on the basis of the buyer’s creditworthiness and the relationship between the buyer and seller.
It is a flexible and convenient form of short-term financing because the buyer can obtain goods or services without making immediate payment.
Thus, Trade Credit represents credit provided directly by the seller to the buyer.
Commercial Paper
Commercial Paper is a short-term, unsecured Promissory Note issued by corporations to raise funds for working capital requirements.
It is a short-term financing instrument used by companies to obtain funds for their operational and working capital needs.
Commercial Paper is generally sold to institutional investors in the money market.
Since it is unsecured, Commercial Paper is not supported by specific collateral. It provides corporations with a cost-effective method of raising short-term finance.
Therefore, Commercial Paper is mainly associated with corporate short-term borrowing and working capital financing.
Factoring
Factoring is a financing arrangement involving the purchase of Accounts Receivable from a business at a discount.
Under a factoring arrangement, a business has receivables arising from sales made to its customers. These Accounts Receivable are purchased by a Factor at a discount.
The Factor provides immediate cash to the business and assumes the responsibility of collecting the receivables from the buyers.
Therefore, instead of waiting for customers to make payment, the business receives funds immediately from the Factor.
Factoring helps a business improve its cash flow and manage credit risk.
The basic process may be understood as:
Business has Accounts Receivable → Factor purchases Receivables at Discount → Business receives Immediate Cash → Factor collects from Buyers
Forfaiting
Forfaiting is a form of trade financing under which a financial institution, known as a Forfaiter, purchases the right to receive future cash flows arising from a buyer’s Promissory Note or another payment obligation.
The Forfaiter provides immediate funds to the seller and assumes the credit risk associated with the future payment obligation.
Thus, the seller does not have to wait for the future cash flows. The seller receives funds from the Forfaiter, while the Forfaiter acquires the right to receive the future payment.
The important feature of Forfaiting is that the Forfaiter assumes the credit risk and provides immediate finance to the seller.
Installment Credit
Installment Credit is a credit arrangement under which a borrower repays a loan through fixed payments over a specified period.
It is commonly used for financing large purchases such as a car or appliance.
The loan agreement specifies the repayment schedule, interest rate, and other terms of the credit arrangement.
Instead of repaying the entire amount at one time, the borrower makes fixed payments according to the agreed schedule.
Therefore, the important characteristic of Installment Credit is repayment through fixed payments over a specified period.
Revolving Credit
Revolving Credit is a credit arrangement that provides a borrower with a pre-approved credit limit that can be accessed as required.
The borrower can use credit up to the approved limit. When the borrowed amount is repaid, the credit may again become available for use.
Revolving Credit is commonly associated with credit cards and lines of credit.
The borrower can repeatedly use and repay the available credit according to the terms of the credit arrangement.
Therefore, Revolving Credit is a flexible form of financing because the borrower does not need to obtain a completely new credit arrangement every time funds are required within the approved limit.
Installment Credit and Revolving Credit
Installment Credit and Revolving Credit are different forms of credit arrangements.
Under Installment Credit, a borrower generally repays the loan through fixed payments over a specified period. The repayment schedule and terms are stated in the loan agreement.
Under Revolving Credit, the borrower receives a pre-approved credit limit and may repeatedly use and repay credit within that limit.
Therefore:
Installment Credit → Fixed payments over a specified period
Revolving Credit → Repeated use and repayment within a pre-approved credit limit
Importance of Instruments of Credit
Instruments of credit play an important role in trade and finance. They provide different forms of credit arrangements, payment guarantees, and financing options to businesses and individuals.
A Promissory Note records a written promise to pay. A Banker’s Acceptance provides a bank’s acceptance and payment assurance. A Letter of Credit guarantees payment subject to specified terms and documents.
Trade Credit permits delayed payment for goods or services. Commercial Paper allows corporations to raise short-term funds for working capital.
Factoring and Forfaiting provide immediate funds against receivables or future payment obligations. Installment Credit permits repayment through fixed payments, while Revolving Credit provides flexible access to a pre-approved credit limit.
Thus, these instruments facilitate trade, improve cash flow, and provide access to different forms of finance.
Important Differences for Examination
| Instrument of Credit | Main Feature |
|---|---|
| Promissory Note | Written promise to pay a specified amount |
| Banker’s Acceptance | Time draft accepted by a bank providing payment guarantee |
| Letter of Credit | Bank guarantees payment subject to specified documents and terms |
| Trade Credit | Seller permits buyer to delay payment |
| Commercial Paper | Short-term unsecured Promissory Note issued by corporations |
| Factoring | Accounts Receivable are purchased at a discount |
| Forfaiting | Future payment obligation is purchased and credit risk is assumed by the Forfaiter |
| Installment Credit | Loan is repaid through fixed payments over a specified period |
| Revolving Credit | Credit can be repeatedly used and repaid within an approved limit |
Exam Focus
A Promissory Note is a written promise to pay, while a Bill of Exchange contains a written order to pay.
A Banker’s Acceptance is a time draft drawn on and accepted by a bank and provides a guarantee of payment.
A Letter of Credit is issued by a bank on behalf of a buyer to guarantee payment to a seller when specified documents are presented and the terms of the LC are fulfilled.
Trade Credit allows a buyer to delay payment for goods or services received and is a form of short-term financing.
Commercial Paper is a short-term, unsecured Promissory Note issued by corporations to raise funds for working capital needs.
Under Factoring, Accounts Receivable are purchased at a discount and immediate cash is provided to the seller.
Under Forfaiting, a Forfaiter purchases the right to future cash flows, assumes the credit risk, and provides immediate funds to the seller.
Installment Credit involves fixed payments over a specified period, whereas Revolving Credit allows repeated use and repayment of credit within a pre-approved credit limit.