Commercial Paper: Meaning and Uses

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. 

1. 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. 

2. 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). 

3. Cheque – Like drafts, these are written in paper forms where the drawee is a bank.  

4. 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.