Liquidity position is of paramount significance in any form of business organisation. Dynamic nature of business, coupled with inherent volatility, quite often poses a challenge to liquidity criterion. Efforts to maintain proper liquidity necessitates the search for resource mobilization alternatives.
Modern firms are in a perpetual race to acquire the cheapest source of finance to leverage their companies and gain comparative advantage in the competitive environment.
Generally, companies are relying on two sources of finance – long-term sources and short-term sources. Long-term sources of finance typically include – Shares, debentures, venture capital, public deposits, government grants, mortgage, retained earnings, loans from financial institutions, loans from commercial banks etc. Whereas, short-term sources of finance include – overdraft, trade credit, factoring, cash credit, loans and advances, discounting of bills, commercial paper etc., these funds maturity period of one year or less. Markets which govern these funds are well known as money markets. And the commercial paper, obviously, is a low-cost alternative to conventional resource mobilization drive.
In India it was introduced in the year 1990 by the then government in the process of continuing reforms to meet the objective of short-term liquidity. That is by releasing the pressure on bank funds for medium sized borrowers and enabling companies with high credit ratings to raise funds directly from the markets
To guide the investors in making rational and informed decisions, it is mandatory for the CP issue to gain a credit rating from recognized agencies. Ratings give an idea as to the risk attached to the CP and the overall picture of the firm. A substandard rating implies that the firm is extremely risky and there is probability that the firm may default on its payment.
In India, Credit Rating Information Services of India Ltd. (CRISIL) and Investment Information and Credit Rating Agency of India Ltd. (ICRA) are the reputed rating agencies. The other notable agencies operating in India are FITCH ratings and Credit Analysis and Research Ltd. (CARE). According to the RBI, for a CP to be issued in India the company must have a minimum credit rating of P-2 as per the CRISIL rating scale or its equivalent.
Since such instruments are not backed by collateral, only firms with high credit ratings from a recognised rating agency will be able to sell their commercial paper at a reasonable price. CPs are usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing company or institution would have to pay. Interest rates will tend to fluctuate with market conditions, but will be lower than Bank rates.
On the flip side CP is not absolutely risk free, there are certain risks attached to CP – credit risk in that the company may be unable to pay the investors on maturity though this is an extremely rare event, interest rate risk which arises due to the changes in the market interest rates. The major risk facing CP is liquidity risk which affects the market as a whole. The whole market turns hostile, interest rates rise and the issuer becomes unable to rollover or make fresh issues.
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