Credit Instruments

Credit instruments are formal documents that acknowledge the borrowing and lending of money or goods with a promise to repay. They are used in trade, banking, and business to ensure clarity, legal validity, and accountability. These instruments define the amount, repayment terms, interest, and responsibilities of parties involved. In India, credit instruments provide a secure way to extend credit, reduce disputes, and maintain financial discipline. They are widely used in banking, commercial transactions, and personal loans. Common credit instruments include promissory notes, bills of exchange, and cheques.

1. Promissory Note

A promissory note is a written, unconditional promise by one party (the maker) to pay a specific sum to another party (the payee) at a predetermined date or on demand. In India, it is governed by the Negotiable Instruments Act, 1881. It must mention the amount, date, payee, and signature of the maker. Promissory notes are simple and widely used for loans between individuals or businesses. They are legally enforceable, ensuring repayment. Banks and financial institutions often use promissory notes for credit facilities. Proper documentation protects both the lender and borrower and provides proof in case of disputes or delayed payments.

2. Bill of Exchange

A bill of exchange is a written order by one party (drawer) instructing another party (drawee) to pay a specified sum to a third party (payee) on demand or at a future date. In India, it is also governed by the Negotiable Instruments Act, 1881. Bills of exchange are commonly used in trade, especially for exports and imports. They help in regulating credit between businesses, ensuring timely payments, and providing legal recourse in case of default. It involves three parties and clearly defines the amount, date, and terms of payment. Acceptance by the drawee makes it legally binding. Banks often discount bills of exchange for immediate funds.

3. Cheque

A cheque is a written order by a depositor (drawer) instructing their bank to pay a certain sum of money to a specified person (payee) or bearer. In India, cheques are governed by the Negotiable Instruments Act, 1881. Cheques are widely used in day-to-day transactions, both personal and business. They provide a safe, traceable, and convenient way of payment without carrying cash. Post-dated cheques can be used as a credit instrument for loans or advances. The bank honors the payment when presented, ensuring security. Dishonored cheques may lead to legal action under Section 138 of the Act. Cheques are crucial in maintaining financial discipline and managing cash flow.

4. Bank Draft

A bank draft is a payment instrument issued by a bank on behalf of a customer, ordering another bank or branch to pay a specific amount to a payee. In India, it is commonly used for secure transactions where the payer cannot make direct payments. Bank drafts are prepaid, meaning the bank guarantees the payment, reducing the risk of default. They are widely used in business, education, and property transactions. Unlike cheques, drafts cannot bounce as the amount is already debited from the customer’s account. Bank drafts provide safety, legal validity, and convenience, making them an important instrument for credit and commercial operations.

5. Credit Card

A credit card is a plastic card issued by banks or financial institutions allowing the holder to purchase goods or services on credit. The cardholder repays the borrowed amount within a specified period, usually monthly, and may incur interest on delayed payments. In India, credit cards are widely used for personal, business, and online transactions. They act as short-term credit instruments, offering convenience, rewards, and easy record-keeping. Banks set a credit limit based on the holder’s income and repayment history. Proper use of credit cards promotes financial discipline, while misuse or delayed payment can lead to penalties, interest charges, and negative credit records. They are a modern and flexible credit instrument.

6. Line of Credit

A line of credit is an arrangement where a bank or financial institution allows a borrower to withdraw funds up to a pre-approved limit as needed. In India, businesses and individuals use it for short-term working capital, emergencies, or flexible spending. Interest is charged only on the amount withdrawn, not the full limit. The borrower can repay and reuse the credit multiple times within the agreed period. This instrument provides liquidity, ensures smooth cash flow, and reduces dependence on loans for small needs. Banks evaluate creditworthiness, repayment capacity, and past performance before approval. Proper management ensures disciplined borrowing and prevents overextension or default.

7. Bills Receivable and Bills Payable

Bills receivable and bills payable are trade credit instruments used to manage payments between buyers and sellers. Bills receivable are amounts a business expects to receive from customers, while bills payable are amounts a business owes to suppliers. In India, these instruments formalize transactions, ensuring clarity of payment dates and amounts. They are often based on bills of exchange or promissory notes. Proper management of bills receivable improves cash flow, while bills payable ensure timely payment to suppliers, maintaining trust. Businesses can also discount receivable bills with banks for immediate funds. Monitoring and recording these instruments reduces default risk and strengthens financial discipline.

8. Letter of Credit

A letter of credit (LC) is a bank’s guarantee to pay a seller on behalf of a buyer once certain conditions are met. In India, LCs are commonly used in import and export transactions to reduce payment risk. It ensures that the seller receives payment even if the buyer defaults. The bank examines documents such as invoices, shipping papers, and contracts before releasing funds. Letters of credit provide security, build trust in international trade, and facilitate smooth transactions. They are flexible and can be revocable or irrevocable. Proper use ensures timely payment, reduces credit risk, and supports business expansion. LCs are widely used by exporters, importers, and banks.

9. Factoring

Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to a financial institution, called a factor, at a discount. In India, factoring helps businesses get immediate funds without waiting for customer payments. The factor takes responsibility for collecting payments from customers, reducing credit risk. Factoring improves cash flow, finances working capital, and allows businesses to focus on operations. There are two types: recourse factoring, where the business remains responsible if customers default, and non-recourse factoring, where the factor bears the risk. It is commonly used by small and medium enterprises (SMEs) to manage liquidity and reduce the burden of credit management.

10. Debit Card

A debit card is a plastic card linked to a bank account, allowing the holder to withdraw money or make payments directly from their account. In India, it is commonly used for cashless transactions, online shopping, and ATM withdrawals. While it is not a traditional credit instrument, it supports cash flow management and short-term credit when overdraft facilities are attached. Some banks offer overdraft debit cards that provide temporary credit. Debit cards are safer than cash, provide transaction records, and reduce risk of default since funds are drawn directly from the account. Proper use ensures financial control, convenience, and transparency in day-to-day payments.