Commercial Paper - Explained
With the introduction of liberalisation in the global market during the year 1985 to 1990, the Indian government introduced several short term debt instruments. One such debt tool is the commercial paper that came into the Indian money market in 1990 and initiated financial reform in India.
To put it simply, it is a short-term debt instrument availed by companies when they need immediate funds to meet their short-term liabilities. These liabilities can be anything from stocking up inventories to financing payroll or others.
According to the Commercial paper definition, this unsecured promissory note comes along with a set maturity and is issued by All India Financial Institutions (FIs) and Primary Dealers (PDs). In India, this period is between 15 days to 364 days.
To understand the concept of CP easily, consider this example. A firm named ABC requires funds to stock up inventory for the upcoming sale season. To do so, they have a deficit of ＄20 Million. In such a case, they can buy commercial paper from the issuers for a face value of say ＄20.1 Million (depending upon prevailing interest rate) and receive＄20 Million cash. So, the ABC Company pays an interest amount of ＄0.1 Million for the deal.
Commercial Paper Market in India
With CP as a debt instrument, the commercial paper market has become a component of the Indian money market. Here, the balance between supply and demand is met by two sections of people –
Issuers (who create supplies)
Subscribers (who create demand)
These two promotes the market and help companies accumulate funds for their short-term financial liabilities or obligations at times of financial crisis.
Types of Commercial Paper
These can be broadly categorised into two parts depending upon the security it offers.
Secured Commercial Papers – These are often known as Asset-backed commercial papers (ABCP) wherein it is backed by physical assets like trade receivables, etc.
Unsecured Commercial Papers – In this unsecured kind, the paper isn’t backed by pledging any asset and is allotted without any security.
Subsequently, the Uniform Commercial Code (UCC) has divided the commercial paper in India into four categories, as mentioned below.
Draft – It is written by one individual to another (usually banks) asking to pay a definite sum to the third party. A drawer, drawee, and acceptor are involved in the process. It can be of two kinds – sight draft and time draft.
Note – Also known as a promissory note, these are written by specifying the amount to be paid after a certain amount of time. Here two parties are involved – promisor (maker) and promisee (payee).
Cheque – Like drafts, these are written in paper forms where the drawee is a bank.
Certificates of Deposit – Often known as CD, this is an acknowledgement form issued by the bank confirming receipt of the deposit. Some of the difference between commercial paper and certificate of deposit is in terms of issuer, denomination, etc.
Features of Commercial Paper
It is a short-term debt instrument tool that is set for a maturity period.
It is usually an unsecured debt where the company doesn’t pledge any asset but still qualifies for it based on their company’s liquidity, revenue-generating power, and achievements.
The commercial paper issuer guarantees or promises to pay the fixed amount to the subscriber in cash in future.
This paper can be used as a certificate of unsecured debt.
Advantages and Disadvantages of Commercial Paper
Mentioned below are some pointers that discuss the merits and demerits of commercial paper. Have a look at these pointers to understand when it is beneficial to avail this paper.
Merits
Since it is mostly unsecured in nature, your company’s assets aren’t on risk.
The method is a quick way to raise funds for working capital. It is a cost-effective method, as well as cheaper than bank loans.
The range of maturity varies, which makes it flexible.
Companies may save extra cash and convert them into good returns to save more through the process.
A customisable maturity range makes the process feasible for companies. Issuers can pay for the matured papers by selling new commercial paper.
Demerits
Even though the commercial paper has several advantages in the Indian market, there can be scenarios that make it inconvenient for certain companies. The amount for which a commercial paper is made is quite high, and since these are unsecured debt, only a few renowned blue-chip and profitable companies can subscribe to this. Besides, the credit available from a bank or financial institution may get reduced after issuing the paper.
Despite a few limitations, this has helped bring financial reform in India and helped companies overcome the financial crisis. You can learn in detail about various such concepts included in the syllabus by visiting Vedantu’s website.
Commercial Papers used Today
Commercial papers do have a vital role in today’s world. In general, they are used to settle the debts that are short-term and also which are unsecured. If you don’t know it has been introduced to India only by 1990. So within the ten years lapse itself, the development it gave is really big.
So to increase the short-term borrowings the companies that are already having higher ratings will use commercial papers. Since they are using the bank and large corporations it is easier to get through the short-term obligations that are faced by newer projects. And in another way, we could say that by using commercial paper (CP) it is easier for any investor to get through the processing even faster.
And the surprising fact is that the commercial paper does have a validity of maturity from a minimum of 7 days. And there is a maturity period of up to one year as well. The only thing we must take care of is that the period must not get over the credit rating date of the owner. So that is why the companies that are having a huge rating are given it.
FAQs on Commercial Paper: Meaning and Uses
1. What is a Commercial Paper (CP) in simple terms?
A Commercial Paper is a type of short-term, unsecured promissory note issued by large, creditworthy corporations to raise funds quickly. Essentially, it is a way for a company to borrow money directly from other companies or institutional investors for a short period, typically ranging from 7 days to one year in India, without involving a bank loan.
2. What are the primary uses of Commercial Paper for a business?
Companies use Commercial Paper primarily to meet their short-term financial needs. Common uses include:
- Working Capital Financing: Funding day-to-day operations like paying salaries or purchasing raw materials.
- Seasonal Funding: Managing cash flow during peak business seasons when more inventory is needed.
- Bridge Financing: Providing short-term funds to cover costs while waiting for long-term financing (like a loan or equity issue) to be approved.
3. What are the three main features of a Commercial Paper?
The three defining features of a Commercial Paper as per the CBSE syllabus are:
- Unsecured Nature: It is not backed by any collateral. The issuer's creditworthiness and reputation are the only guarantee of repayment.
- Short-Term Maturity: In India, the maturity period must be between a minimum of 7 days and a maximum of one year.
- Issued at a Discount: CPs are typically issued at a price lower than their face value and redeemed at par. The difference between the issue price and face value represents the interest earned by the investor.
4. Who is eligible to issue and invest in Commercial Papers in India?
In India, the eligibility for issuing and investing in CPs is regulated. Issuers are typically large corporations, Primary Dealers (PDs), and All-India Financial Institutions (FIs) that have a high credit rating from an approved agency like CRISIL. Investors include individuals, banking companies, other corporate bodies, and Foreign Institutional Investors (FIIs).
5. How does a Commercial Paper (CP) differ from a Certificate of Deposit (CD)?
While both are short-term money market instruments, their key difference lies in the issuer. A Commercial Paper is issued by highly-rated corporations and financial institutions to borrow money. In contrast, a Certificate of Deposit is issued only by commercial banks and specified financial institutions to raise money from depositors.
6. Why is a Commercial Paper considered an unsecured instrument, and what are its implications?
A Commercial Paper is called unsecured because the issuing company does not pledge any specific asset or collateral as security for the loan. The investor's confidence is based solely on the company's financial health and high credit rating. The main implication is risk: if the company defaults, the investor has no claim on its assets, which is why only financially strong, reputable companies can successfully issue CPs.
7. Why can't a new startup or a small company issue Commercial Paper?
A new startup or small company cannot issue Commercial Paper because of the stringent eligibility criteria set by regulators. To issue a CP, a company must have a high specified credit rating from an agency like CRISIL and a significant tangible net worth. Startups and smaller firms typically lack the long track record of profitability and financial stability required to secure such a high rating, making this financing option unavailable to them.
8. What is the role of the Commercial Paper market in the Indian economy?
The Commercial Paper market is a vital component of the broader money market. It provides a platform for creditworthy corporations to access short-term funds at a lower cost than traditional bank loans. This promotes liquidity in the financial system, allows companies to manage their working capital efficiently, and offers investors a low-risk, short-term investment opportunity, thereby balancing the supply and demand for short-term capital.
