Working Capital Management Question:
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Tell me what are bank guarantees? How do they work?

Answer:

Bank Guarantee is a non fund based lending given by the bank to ensure that the liabilities of a debtor will be met. This facility enables the customer to acquire goods, buy equipment and thereby expand business activity. This process can be explained with the help of an example. Suppose X and Y are two companies both unknown to each other, in which X wants to purchase some material from Y Company. As the company Y does not know the company X and is concerned whether company Y will make the payment or not. Bank Z of Company X opens the bank guarantee in favour of company Y Bank Z in which it undertakes to make the payment to Company Y, if the company fails to make payment to company Y. In this way, interests of company Y are protected as it is assured to get the payment either from company X or from its Bank Z. As such, it becomes non fund based lending for Bank Z as it does not commit any outflow of funds. Bank Guarantee transactions will be applicable in case of credit transactions.

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