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Banking and Insurance - Laws and Practice · Advances, Securities and Documentation

Principles of Sound Lending and Types of Advances

Updated 11 October 2026 · Fact-checked

Sound lending means a banker lends only where the money is safe, can be recovered when needed, earns a fair return and goes to a genuine purpose. Advances take the form of term loans, cash credit, overdraft and bill discounting. Each differs in how funds are drawn, repaid and secured.

Understand Principles of Sound Lending and Types of Advances

A bank lends money that belongs mostly to depositors. So it cannot lend as freely as a private person. It must lend in a way that protects depositors and still earns a return. This is why bankers follow a set of principles before sanctioning any advance.

The core principles are:

  • Safety: the borrower must be able and willing to repay, and the security must cover the risk. Check character, capacity and the value of security.
  • Liquidity: money lent should come back when the bank needs it. Deposits can be withdrawn, so advances should be repayable on a schedule or on demand.
  • Profitability: interest earned must cover the cost of funds, operating cost, and risk, and leave a margin.
  • Purpose: the bank must know why the money is needed. A productive and lawful purpose makes repayment likely. Lending for a purpose that is illegal or speculative is avoided.

Other commonly taught principles are diversification (do not put too much in one borrower or sector), security (collateral as a back-up, not a substitute for repayment ability) and national policy and regulatory compliance (priority sector targets, RBI directions). The exact list varies between books, so write the four main ones first and add the rest as extras.

The forms of advances follow from how the borrower needs money:

  • Loan: a fixed sum is paid to the borrower in one go or in instalments, and is repaid as agreed. Interest runs on the amount outstanding. Term loans suit fixed assets.
  • Cash credit: the bank sets a limit against security, usually stock and book debts. The borrower draws and repays within the limit as needed. Interest is charged only on the amount used. It suits working capital.
  • Overdraft: the borrower with a current account is allowed to draw more than the balance, up to a sanctioned limit. It is usually meant for temporary needs and may be secured or clean.
  • Bill discounting: the bank pays the holder of a bill the amount less discount, then collects the full value from the drawee on the due date. The bank earns the discount.

The borrower must also not be misled or pressured. A contract of loan that the borrower enters under undue influence is voidable. Under section 16 of the Indian Contract Act, 1872, undue influence exists where one party is in a position to dominate the will of the other and uses that position to obtain an unfair advantage. Banks must therefore document advances fairly.

Key rules to remember

Principles of sound lending
Safety + Liquidity + Profitability + Purpose (plus diversification and compliance)
Write the four main principles with a line of explanation each. Mention extras only after them.
Discount on a bill
Discount = Bill amount × Rate ÷ 100 × Unexpired period (in years)
Proceeds = Bill amount − Discount. Use days ÷ 365 for the period unless the question states otherwise.
Interest on cash credit or overdraft
Interest = Amount outstanding × Rate ÷ 100 × Days ÷ 365
Interest is charged only on the amount actually drawn for the days it stays drawn, not on the full limit.
Undue influence (section 16, Indian Contract Act, 1872)
Position to dominate the will + use of that position to obtain an unfair advantage
Where the dominant party contracts and the transaction appears unconscionable, the burden of proving no undue influence lies on that dominant party.

How to solve Principles of Sound Lending and Types of Advances questions

Use this order for theory and case questions on lending principles and types of advances.

  1. 1Read the question and identify whether it asks for principles, a type of advance, a comparison or a case.
  2. 2Define the term in one or two lines in plain words.
  3. 3List the relevant principles (safety, liquidity, profitability, purpose) and explain each with the facts given.
  4. 4For a type of advance, state how funds are given, how repaid, how interest is charged and what security is usual.
  5. 5If it is a comparison, use points such as purpose, drawing, repayment, interest base, security and operation of account.
  6. 6Apply the facts: check borrower's purpose, security, repayment source and any sign of pressure or unfair terms.
  7. 7State your conclusion clearly, for example which advance suits the borrower or whether the bank should sanction.

Quickest way: Four principles, then match the advance to the need

When to use it: When time is short and the question asks which advance or principle applies.

  1. Say the four principles in one line each.
  2. Ask: is the need fixed-asset (term loan), day-to-day working capital (cash credit), temporary shortfall in current account (overdraft), or sale on credit (bill discounting)?
  3. Add one sentence on security and interest base for the chosen advance.
  4. Close with a one-line conclusion.

Common mistakes in Principles of Sound Lending and Types of Advances

  • Saying cash credit and overdraft are the same

    Both allow drawing up to a limit and charge interest on the amount used.

    Fix: Remember cash credit is a separate account usually against stock and book debts for working capital. Overdraft is a facility on a current account, usually for temporary needs.

  • Treating security as the main test of sound lending

    Students think a well-secured loan is always safe.

    Fix: Explain that the first source of repayment is the borrower's income or cash flow. Security is only a back-up.

  • Confusing liquidity with profitability

    Both relate to money and return.

    Fix: Liquidity is about getting money back when needed. Profitability is about earning more than cost and risk.

  • Computing interest on the full limit

    Students forget that the limit is not the amount drawn.

    Fix: Charge interest only on the amount outstanding for the days it is outstanding.

  • Ignoring purpose in case questions

    Students jump to security and amount.

    Fix: Always state the purpose first and check that it is lawful and productive.

  • Writing bill discounting as a loan to the drawee

    The word discount is unfamiliar.

    Fix: The bank buys the bill from the holder at a discount and recovers the full amount from the drawee on maturity.

Worked examples

Example 1

Sharma Traders holds a bill of ₹2,00,000 drawn on a customer, due in 73 days. Its bank discounts the bill at 12% per annum. Calculate the discount and the amount the bank pays. Also state which principle of lending the bank mainly relies on here.

Show the solution
  1. Unexpired period = 73 ÷ 365 = 0.2 years.
  2. Discount = 2,00,000 × 12 ÷ 100 × 0.2.
  3. 2,00,000 × 12 ÷ 100 = 24,000. Then 24,000 × 0.2 = 4,800.
  4. Proceeds = 2,00,000 − 4,800 = 1,95,200.
  5. The bank mainly relies on liquidity and safety: the bill is short term and repaid by the drawee on the due date.

Answer: Discount is ₹4,800 and the bank pays ₹1,95,200. The bank relies on liquidity, since repayment comes at a fixed short date, and on the drawee's ability to pay.

Example 2

Mehta Industries has a cash credit limit of ₹10,00,000 at 10% per annum. During a 30-day month it draws ₹6,00,000 for the full month. Compute the interest for the month. Then explain how an overdraft would differ.

Show the solution
  1. Interest is charged on the amount drawn, not the limit.
  2. Interest = 6,00,000 × 10 ÷ 100 × 30 ÷ 365.
  3. 6,00,000 × 10 ÷ 100 = 60,000. Then 60,000 × 30 ÷ 365 = 18,00,000 ÷ 365 = 4,931.51 approximately.
  4. So interest is about ₹4,932.
  5. Difference: an overdraft is allowed on a current account to meet temporary needs and may be secured or clean. Cash credit is a separate working capital account against stock and book debts.

Answer: Interest for the month is about ₹4,932. Cash credit is a working capital limit against stock and debts, while overdraft is a temporary facility on a current account.

Exam tips

  • Start principle answers with the four main principles in order, then add extras.
  • In comparison questions, use a point-wise list covering purpose, drawing, repayment, interest and security.
  • In case questions, link each fact to a principle and end with a clear recommendation.
  • Show interest and discount calculations in steps. Method marks matter in a written paper.
  • Mention section 16 of the Indian Contract Act, 1872 only when facts suggest pressure or unfair terms.

Practice questions from Advances, Securities and Documentation

Principles of Sound Lending and Types of Advances: frequently asked questions

What are the principles of sound lending?

The main principles are safety, liquidity, profitability and purpose. Many books add diversification, security and compliance with national policy and RBI directions.

What is the difference between cash credit and overdraft?

Cash credit is a working capital limit against stock and book debts, run in a separate account. Overdraft lets a current account holder draw beyond the balance up to a limit, usually for temporary needs.

How does bill discounting work?

The bank pays the holder the bill amount minus a discount now. On the due date it collects the full amount from the drawee. The discount is the bank's earning.

Is security more important than the borrower's ability to repay?

No. The borrower's ability and willingness to repay come first. Security is a back-up if repayment fails.