Performance guarantee is used as collateral in transactions involving a buyer and a seller. A performance guarantee is typically invoked if the buyer incurs cost and the seller does not deliver goods or services as promised in the contract. To invoke a performance guarantee, the beneficiary requires to declare in writing that the seller did not fulfil his or her contractual obligations properly or on time.
The bank has to discharge the financial liability of the contract agreed in the guarantee, if the contract is partly or fully not performed by the customer. Such type of guarantees issued by the bank is called Performance Guarantee. Many a time the terms of the contract may be of highly technical in nature and bank is generally not expected to know the technical aspects of the contract. Therefore, the bank assumes only the financial liability of the contract. Since the issuance of performance guarantee is more complicated and riskier, before issuing performance guarantees, the bank has to ensure that the customer has sufficient experience in the line of business and he has capacity and means to carry out the obligation under the contract.
A financial guarantee is an undertaking from a bank to take responsibility for another company’s financial obligation if that company does not meet its responsibility. The bank provides financial guarantees mostly between two related parties, i.e., a partner company providing a financial guarantee to a subsidiary company.
This cash security provided by the contractor or supplier is forfeited by the Government Department or the company which awarded the contract, in the event the contractor or supplier fails to comply with the terms stipulated in sanction. The customer normally will have an option to furnish a bank guarantee in lieu of cash security, so that his working funds are not unnecessarily blocked. The guarantees issued by banks for above purpose is called financial guarantee wherein the banks undertake to pay the guaranteed amount during a specified period on demand from the beneficiary. The examples of Financial Guarantee are as under.
Deferred Payment Guarantees
Deferred payment guarantees are used when one party in a transaction undertakes to make payment of fixed amount at corresponding times in the future. In case, the debtor is unable to pay, then the deferred payment guarantee can be invoked to claim the money. Thereby the buyer’s bank guarantees due payment of those drafts drawn by the seller which represents the total consideration of the contract of sale/supply. The seller avail the refinance from his bank against co-accepted bills. DPG involves substitution of the term loan. Hence procedure applicable for assessment of term loan must be followed for DPG limit viz. projection under operating statement, Funds flow statement, DSCR, BEP etc.