Chapter 1: Introduction

1. What is “credit”?

Credit can be defined as “the power or ability to obtain money, goods and services at
the present time in exchange for a promise to pay with money upon demand or at a
future determinable time.”

Credit is based on confidence in the debtor’s ability to make payment at some future
time.

Why does “credit” exist?

- It exists because there is a need or desire to obtain economic goods ahead of the
capacity to pay.

- Not all individuals or institutions have the same capability to obtain credit. It greatly
depends on how the debtor can convince the creditor to trust him/her/it.

- Credit is an important part of our everyday life, both on a personal and business level.
Credit is used not only among individual consumers, retailers, wholesalers, and
manufacturers, but also among national, provincial and local governments.

2. Functions of credit:

A school of thought describes “credit” as a medium of exchange because it avoids the

use of money. In other words, credit acts as a substitute for money. It allows the transfer
of goods and services from one person to another.

It is said that “credit” results in the growth of the economy through facilitating the
production and consumption of goods and services.

Some people consume more than what they can afford. In this case, expenses are
greater than their income/revenue. But just because their expenses are greater than
their income at any point in time, it does not mean that they cannot avail of the goods
and/or services they want to consume. This is where credit comes into the picture.

Another school of thought sees credit as elevating the moral standards of people since
anyone who wishes to have credit has to prove himself/herself worthy of trust (credit
after all, is based on trust and confidence).

Credit causes people to save. People believe that by saving, they may use that to make
a profit. When people save money in banks, this will be lent out by banks for production
or consumption, thereby contributing to the growth of the economy. Another example is
when people obtain appliances and cars or houses on installment credit. In this case,

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they are forced to set aside a portion of their monthly income to pay for such
obligations.

Businesses also get the capital they need for large-scale production in the form of credit
either through loans from banks or other financial institutions. The sale of bonds and
stocks is also a form of indebtedness (to the shareholders/stockholders).

Credit allows wealth to be fully utilized. Fixed assets such as a house for individuals, or
buildings/premises for businesses, can be used as collaterals while they avail of
credit/cash to use for other purposes at the same time that they are also using the
house/building.

Credit also has an effect on the amount of money circulated in the economy. The
Central Bank can expand or contract money supply depending on the economic status.
If, for example, the Central Bank decreases the discount rate, then businesses and
individuals will be encouraged to borrow money, or avail of credit from banks and other
financial institutions. This, in turn, will expand money supply in the economy. On the
other hand, if the Central Bank increases the discount rate, this will discourage
businesses and individuals to borrow money. This will result in the contraction of money
supply in the economy.

Furthermore, the Central Bank can also expand the money supply in the economy by
decreasing the amount of reserves required against the deposit liabilities of banks.
Alternatively, if inflation is high, the Central Bank can contract the amount of money in
circulation by increasing the reserve requirements against deposit liabilities of banks.
This is just how credit can be contracted and expanded.

3. Characteristics of Credit:

There are five (5) characteristics of credit:

i. Credit as a Bipartite Contract: credit always involves two (2) parties: the debtor who
obtains the money, goods or services in exchange of his/her promise to pay at a future
date; and the creditor who lends his/her money, goods or services for the right to collect
on demand or at a future determinable date.

ii. Credit as a Pecuniary Contract: credit is always expressed in terms of money. For
example, when we buy goods on credit from a retail store or borrow money from a bank,
it is understood that such obligations shall be paid in money in the future.

iii. Credit as a Fiduciary Contract: credit is based on trust and confidence; the debtor
must always be able to merit the trust and confidence of the creditor. Without this, there
can be no credit transaction.

iv. In credit, risk is always involved: there is always the possibility of the obligation not
being paid. For example, the debtor loses his income or dies, or becomes bankrupt, or

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other experiences unforeseen events, which may prevent him/her from paying
obligations.

v. Credit always involves futurity: payment on credit is always done at a future date. In
actual accounting practice, futurity means a day or more after the credit is obtained.
Goods obtained in the morning and paid in the afternoon do not constitute credit in the
books of business.

4. Significance of credit:

As mentioned earlier, credit allows the production and distribution of goods and
services. As the economy expands, businesses can avail of credit to increase their
production of goods and services. Credit plays a role in providing financial means for
businesses to take advantage of market opportunities in both domestic and foreign
markets.

In short, credit allows consumers to buy goods and services that are beyond their ability
to buy or what they can actually afford at a point in time. In the hands of consumers,
credit affects the amount of goods and services consumed. This implies that credit
actually helps economies grow. For example, today, many families depend on credit to
finance new homes and automobiles (in installment credit).

5. Credit and the Business Cycle:

During periods of economic growth, consumption of goods and services increases. This
encourages individuals and businesses to also make more use of credit. On the other
hand, in times of recession, demand for goods and services decreases. This means that
individuals and businesses have less need for credit to finance their purchases or
operations.

6. Different types of credit:

i. Personal Credit: this is credit obtained for personal use. It falls under three (3)
categories: a. Service credit b. Retail credit c. Personal loan credit

a. Service credit: credit we obtain for services provided by professionals like doctors,
lawyers, etc.

b. Retail credit: credit obtained for goods. It falls under three (3) categories: 1. regular
charge account 2. revolving charges 3. installment plan. In the regular charge account,
we are charged the goods obtained on credit and the debtor has to pay usually within
15 to 20 days after billing. With a revolving charge, the credit will be paid in full within a
period of time and divided into amounts or installments. An example is the use of credit
cards. Installment plan is similar to the revolving charge in that the debt is also paid off
over a certain period of time. The difference, however, is the creditor usually requires a
down payment. The payment period could range from 12 to 36 months, depending on

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the debtor’s ability to pay. In the event of default on two or more payments, the good
sold on credit will be repossessed by the creditor. Note that only durable goods are sold
on installment. This kind of credit is usually obtained for cars, appliances, real estate
and furniture.

A personal loan credit differs from other forms of consumer credit in that cash or money
is given as credit instead of goods and services. Personal loans can be obtained from
banks, other financing institutions such as pawnshops, insurance companies, credit
unions, loan associations, etc.

Personal loans are usually granted for the purchase of expensive consumer items like
real estate (houses), automobiles and the like. A good source of this credit is the Social
Security System (SSS) for private employees and employers and the Government
Service Insurance System (GSIS) for government employees. There are also other
building and loan associations like the Pag-Ibig Fund, etc.

6A. Criteria for Granting Personal Credit:

A person’s wealth and profession/employment are the best criteria for granting personal
credit. Wealthy people can usually pay on time. Wages and salary affect a person’s
capacity to repay credit.

Other factors taken into consideration when granting personal credit is size of the
family, additional sources of income of family, operating expenses of the debtor, paying
habits of debtor.

Occupation is also an important factor because some occupations are riskier than
others. Length of employment and job stability are indicators of credit risk. Permanence
of residence is also another factor to be considered. The length of time a person has
lived in an area is also another indicator of risk.

6B. Lending Act of the Philippines:

The “Truth in Lending Act” is an act designed to protect consumers against unfair billing
practices of people who extend credit to a purchaser of goods on installment basis.
Through this act, citizens are aware of the real cost of credit.

The law requires creditors to provide each customer with the following information
before any transaction is consummated:

1. The cash price of the property to be serviced or acquired

2. The down payment if any, or the trade-in price
3. The difference between the amounts under 1 and 2.
4. The charges individually itemized, which are paid or to be paid in connection with the
transaction and which are not incidental to the extension of credit
5. The total amount to be financed

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6. The finance charged expressed in terms of pesos.
7. The percentage that the finance charge bears to the total amount to be financed
which is expressed as a simple annual rate on the outstanding unpaid balance of the
obligation.

The creditor who fails to disclose any of the above information is deemed to have
violated this act and is liable upon conviction to pay the amount of Php100.00 or an
amount twice the finance charge required by him in connection with such transaction
whichever is greater, except that such liability should not exceed Php200.00 on any
credit transaction. This is payable within one year.

Any person who willfully violates the provision of the act shall be fined by not less than
Php5,000.00 or imprisoned for not less than six (6) months or not more than one year,
or both.

ii. Commercial or Mercantile Credit: credits extended by one businessman to another

businessman. Manufacturers extend a mercantile credit to a wholesaler, and
wholesalers to retailers. These transactions are called merchandise credit or trade
credits because they are in the form of goods. This is how they differ from cash credits.

Commercial or mercantile credit facilitates the movement of goods through the different
stages of production and distribution.

iii. Bank Credit or Bank Loans: credits granted by banks to businessmen to finance
their short-term credit needs. Commercial banks usually grant these loans to finance
current business operations, goods in process, temporary working capital needs and
storage of inventories, or purchase of inventories. Repayment is often within a short
period of time because the turnover of the goods is fast.

iv. Export and Import Credit: export credits are obtained to finance the selling of
goods outside the country. Import credits are also obtained to finance the buying of
goods from other countries. These are obtained from banks. A bank credit is introduced
to international trade through the use of letters of credit and drafts.

v. Investment Credit: long-term borrowing is one of the most common forms of

financing used by businesses. When a business acquires funds through long-term
borrowing, it is using investment credit. Often, investment credit is used to finance costly
productive and marketing facilities. The credit is often used to acquire fixed assets such
as land, buildings, heavy equipment and machinery.

vi. Agricultural Credit: credits given to farmers for the development, improvement and
cultivation of their lands. They may be in the form of a crop loan, livestock loan,
agricultural time loan (used for the development and improvement of farmland),
commodity loan (obtained to finance the selling and distribution of farm crops). Principal
supporters of agricultural loans in the Philippines are the Development Bank of the
Philippines (DBP) and the Land Bank of the Philippines (LBP).

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vii. Industrial Credit: loans granted to industries to finance acquisition of equipment
and machinery, to finance the construction of plant or factory, and to some extent
finance the purchase of raw materials for manufacturing capital goods or goods for
consumption purposes.

viii. Real Estate Credit: loans used to purchase and improve real estate properties like
a house or a building. Usually, these loans are paid off by installment over a period of
time.

ix. Government or Public Credit: credits obtained from any of the government
institutions or other instruments. The debtor may be the national, provincial or local
government. Nowadays, government expenditures such as building of roads, bridges,
irrigation systems, etc. have expanded tremendously. As such, the government has
been relying heavily on credit borrowing from both domestic and foreign sources.

x. Secured and Unsecured Credits: secured credits are credits covered by properties
of value called collaterals to guarantee loans. When the borrower fails to pay his loan
when it falls due, the creditor has the right to foreclose the mortgage and have such
properties disposed off to satisfy the former’s obligation, including interests and other
charges and expenses accruing to the loan.

An unsecured credit, on the other hand, is where the borrower has merited the full trust
and confidence of the creditor; that is, the creditor is willing to part with his money,
goods or services for just a mere promise to pay. This is sometimes called a “character
loan” or a “clean loan” since no property of value was pledged to secure it.

xi. Short-term, medium-term and long-term loans: short-term loans are payable
within one (1) year like commercial bank loans, retail credits, regular charge accounts,
and revolving charge. Medium-term loans are payable from one (1) year to five (5)
years. It is sometimes called an “intermediate term loan”. Examples include car loans
and installment plans on appliances. Long-term loans are payable beyond five (5) years
up to 15 to 20 years. Examples are real estate loans and investment loans.

xii. Direct loans, discount loans and credit lines: direct loans are loans whose
interest payments are made at the time the loan matures. As such, the borrower gets
the entire amount applied for and upon maturity of the loan, pays the principal plus the
interest.

Discount loans are loans where interest payments are deducted at the time the loans
are granted. The borrower obtains only the proceeds of the loan, that is the principal
minus the interest. Upon maturity, the debtor pays the entire amount loaned.

Credit line is an agreement between the debtor and the creditor wherein the debtor is
allowed to obtain funds from the creditor up to a certain amount.

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7. Sources of credit:

Banks: banks are the most common sources of credit. Most of the commercial credits
and agricultural credits are obtained from banks.

Banks are classified as commercial banks, thrift banks, rural banks and specialized
government banks.

Commercial banks specialize in giving commercial credit to businesses. The thrift bank,
which is sub-divided into savings and mortgage banks, stock savings and loan
association and private development banks, also gives loans to individuals for their
personal needs and to the industry for the improvement of agriculture and the economy.

Rural banks cater to the needs of farmers and small businesses in the rural areas
including cottage industries.

8. Other Sources of Credit:

i. Retail stores: one of the biggest sources of personal credit. Almost every “sari-sari”
store has customers who are given personal consumer loans on an open book account
basis.

ii. Credit Unions: cooperative organizations that lend savings of their members to other
members who are in need. This is one of the cheapest sources of credit since borrowing
members pay a very low interest on loans. They can afford to charge low interest rates
for loans because they do not run for profit but for servicing the needs of members.

iii. Individual money lenders: individuals who have excess funds and who usually lend
such funds to others who are in need. The tendency is usually to charge high interests
because the risk entailed is great. Most of the borrowers do not have collaterals and
loans are mainly based on their character. They are sometimes referred to as “loan
sharks” or “usurers” because of the practice of charging high interests.

iv. Insurance companies: these are also sources of credits for insured individuals.
Individuals could borrow from their insurance companies an amount equivalent to the
case surrender value of their policy. Cash surrender value refers to the value of a policy
as it is surrendered after paying premiums for several years.

v. Sales Finance Companies: one of the biggest sources of consumer credit. They also
extend credit facilities to industrial, commercial and agricultural enterprises. They also
lease motor vehicles, heavy equipment, industrial machinery and business equipment.

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9. 5Cs of Credit (traditional):

One of the characteristics of credit we mentioned before is that it always involves risk.
This is the possibility that, for whatever reason, the borrower/debtor is not able to pay
his/her obligation when it falls due. Credit risk, however, may be minimized by a careful
examination of the 5Cs of credit.

The 5Cs of credit are:

i. Character: a quality of credit risk. Character makes the debtor pay or intend to pay
when his debt is due. A person’s character is the sum total of his mental and moral
qualities. Character is what makes a borrower conscientiously concerned about his
obligations. As a creditor/lender, judgment of character must be based upon evidence.
The gathering and appraisal of evidence is the job of the credit manager. Evidence can
be obtained from historical credit records.

Other evidences of character are the position held by the individual in a business or in
social organizations, stability of employment and business connections.

ii. Capacity: this signifies the ability of a debtor to pay his obligation. A debtor may be
willing to pay his debt, but may not have cash with which to pay when it falls due. This
includes the ability of a company or management to make good its commitment.
Evidence of capacity can be taken from the company’s financial statements, creditor’s
appraisal of its management, and information from credit rating agencies.

iii. Capital: the financial strength of a business. To the creditor, this is the guarantee that
a credit transaction entered can be redeemed. Capital is the difference between total
assets and total liabilities. This is the net worth of a business.

iv. Collateral: this is a property of value pledged to secure a loan. It may be personal or
real properties. This includes financial and other resources such as bank deposits,
inventories, receivables and other assets that the company can pledge for loans. Loans
secured by movable personal properties are called “chattel mortgages” and loan
secured by fixed assets are called “real estate mortgages”. Other collaterals may be in
the form of: stocks and bonds, signatures of co-makers and co-signers, hold outs on
deposits and pledges on receivables.

v. Conditions: these refer to the environment in the customer’s industry; economically,

legally and politically in relation to growth. These are external factors over which the
credit applicant has little or no control but which may have significant influence upon the
appraisal of credit risk.

Most businesses are subject to two (2) types of movement, namely: 1. regular recurring
seasonal activity and 2. the regular oscillation of business as a whole. The agricultural
industry for instance is a seasonal industry. Textiles, toys and school supplies are also
seasonal. The second movement may be in contrast with the larger movement

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commonly known as the business cycle. Credit conditions may be generally good in
some industries while the status of a particular industry as a whole may be one of
general depression. Business movement oscillates. When the economy is down, the
creditor needs a staunch character, a high capacity reinforced by a high margin of
capital.