LEARNING MODULES IN FM 6 CREDIT AND COLLECTION

This includes Module 1 and 2

MODULE 1
This module provides an overview of the fundamentals of credit as review from
the topics in basic finance. This provides students on credit importance and
awareness on the possible impact of credit if not properly utilized. This covers
the definition of credit, elements of credit, bases of credit, advantages and
disadvantages of credit and other relevant topics which explains the existence
of credit and credit transactions.

TOPICS

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Definition, Nature,
Advantages and
Disadvantages of Credit

MODULE 1
DEFINITION, NATURE, ADVANTAGES AND DISADVANTAGES OF
CREDIT

Credit is one of the unique

features of our business
system. Business firms sell
to consumers on credit and
buy from other
businessmen on credit. The
word credit comes from the
latin word “CREDERE’ or
“CREDITUM” which means
“To Trust”. The wide
spread use of credit is a
strong evidence to support
the belief that people have
trust in one another.

In the emergence of credit, it might be helpful to point

out, is not one of design but rather, it is a product of
necessity. Thus, it may be logical to expect, it passed
through a long process of evolution and development.

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How do you define credit? This term is broad

with many different meanings in the financial
world. Credit is generally defined as a contractual
agreement in which a borrower receives
something of value now and agrees to repay the
lender at a later date—generally with interest.
Credit is generally defined as an agreement
between a lender and a borrower, who promises
to repay the lender at a later date—generally with
interest.
Credit also refers to an individual or
business' creditworthiness or credit history.
In accounting, a credit may either decreases
assets or increases liabilities and equity on a
company's balance sheet.

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For example, when someone uses his or her Visa card to make a purchase, the card is
considered a form of credit because they are buying goods with the understanding they will
pay the bank back later.

Financial resources are not the only form of credit that may be offered. There may be an
exchange of goods and services in exchange for a deferred payment, which is another type of
credit.

When suppliers give products or services to an individual but don't require payment until
later, that is a form of credit. So when a restaurant receives a truckload of food from a vendor
who doesn't demand payment until a month later, the vendor is offering the restaurant a form
of credit.

Credit is defined as the ability to obtain a thing of value in exchange for a promise to pay
definite sum of money on demand or future determinable time. A thing of value may mean
cash, goods or services.
Credit may also mean the ability to possess goods, services or even money in exchange
for a promise to pay it equivalent in monetary units at determinable future time.
Credit is an arrangement that allows to buy goods or services now and pay for them later.
It can also be understood to mean these transactions or exchanges in which payment is
to be expected at some time after acceptance of the goods or money.
In the first and most common definition of the term, credit refers to an agreement to
purchase a good or service with the express promise to pay for it later. This is known as buying
on credit. The most common form of buying on credit is via the use of credit cards. People tend
to make purchases with credit cards because they may not have enough cash on hand to make
the purchase. Accepting credit cards can help increase sales at retailers or between
businesses.

The amount of money a consumer or business has available to borrow—or their

creditworthiness—is also called credit. For example, someone may say, "He has great credit,
so he's not worried about the bank rejecting his mortgage application."

Service credit is an agreement between a consumer and a service provider such as a

utility, cell phone, or cable service.
In other cases, credit refers to a deduction in the amount one owes. For example, imagine
someone owes his credit card company PhP1, 000, but he returns a purchase worth PhP300
to the store. He receives a credit on his account and then owes only PhP700.

Finally, credit is an entry that depicts in accounting to increase assets or decrease liability.
So a credit increases net income on the company's income statement while debit reduces net
income.

For whatever it is worth, credit stems from trust- thus credit business would mean
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Credit is a very powerful and excellent device in the economy that accommodates
transactions smoothly and effectively without the use of money in the time of transaction.
Credit is considers to be the “Life-Blood of Business”. A business firm which sells goods
in credit confers benefits to its customers just as it helps the continued operation of its
business. Through credit, an increase in the volume of sales is expected by the firm.

Credit connects our business and financial

enterprises in an invisible but mighty chain. Unfortunately,
failure in one sector of the economy generally spreads
rapidly to others until they engulf the whole economy.
It must be emphasized that credit represents the vey
force that sustains and aids business in the attainment of
its objectives. This is apparent, if not obvious, to say the
least. It is only through credit that business transactions
in large volume become possible. Credit not only finances
trade and commerce in almost every conceivable way, but
it also provides the needs of seasonal business.

Based from the definition of credit, the following elements were present:
1. It is the ability to obtain a thing of value — A thing of value may mean cash form of
credit, merchandise or even services.
2. A Promise to pay --- the borrower (Debtor) makes a promise to pay the lender
( Creditor). A promise to pay is valid if it is through writing and acknowledge by both
parties wherein the amount of the loan, interest and maturity is specified.
3. Definite Sum of Money --- Credit involves the exact amount of money loaned or
extended by the creditor to the debtor.
4. Payable on Demand or Future Time --- Credit has specific date when to settle the
obligation , if none, it is considered to be payable on demand or anytime the creditor
demands for payment.

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CHARACTERISTICS OF CREDIT
1. It is a bi-partite or two-party contract. Two parties are involved in the credit agreement,
the debtor and the creditor. The debtor is the party requesting for the loan while the party
extending the loan is the creditor.
2. It is elastic. The amount of credit may be increased or decreased in value by the creditor,
this usually depends on the value of the collateral pledge by the debtor.
3. The Presence of Trust and Faith. The creditor rely more on the debtor’s ability and
willingness to pay his debt. This is also the risk factor in credit particularly when the debtor
was not able to fulfill his obligation.
4. It involves futurity. Credit has its maturity for the settlement
of obligation.

For the credit system to continue in its existence and attain a

healthy growth and development, it is necessary that it should
be anchored a strong pillars/foundations for support. As
observed, the foundations of credit are:

1. Confidence. Creditors must have absolute confidence in the personal character

and in the ability as well as willingness of their debtors to accept honor and settle their
obligations.
2. Proper Facilities. This exist in performing credit operations, sources of
credit information must be available to those granting credit. If a correct and proper
evaluation of credit rating is to be made which is the first criterion in the grant of credit. Credit
Information includes data about the debtor as a gauge of his paying capacity which can be
gathered out of a conduct of credit investigation. Moreover, a credit document should be
present which serves as a written agreement signed by both parties.
3. Stability of Monetary Standards. Money must be stable wherein the
purchasing power of money is considered when extending credit. The more stable the value
of money is, the greater the possibility for approving credit.
4. Government Assistance. Government must stand ready to assist the creditor
in enforcing payment of loans extended to debtors. Debtors are given more protection since
they cannot be imprisoned for non-performance of obligation that is they do not have any
asset or property. In this case, the creditors take the risk.
5. Credit Risk. It is the possibility that the debtor may not fulfill his obligations. Credit
risk shall be borne by the creditors.
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C’s OF CREDIT
The five C’s, or characteristics of credit — character, capacity, capital,
conditions and collateral — are the framework used by many traditional lenders
to evaluate potential borrowers.

1. Character

What it is: A lender’s opinion of a borrower’s general trustworthiness, credibility and

personality.
Why it matters: Banks want to lend to people who are responsible and keep
commitments.
How it’s assessed: From your work experience, credit history, credentials, references,
reputation and interaction with lenders.
How to master it: “Character is something you can control and promote, but only if you
have a bank that cares about relationships,” Farris says.
If you use a local or community bank, build a relationship. Farris recommends sharing
good news about your business with your banker and finding ways to promote the bank.
“Make yourself someone they want to lend to,” he says.

2. Capacity/Cash flow

What it is: Your ability to repay the loan.

Why it matters: Lenders want to be assured that your business generates enough cash
flow to repay the loan in full.
How it’s assessed: From financial metrics and benchmarks (debt and liquidity ratios,
cash flow statements), credit score, borrowing and repayment history.
How to master it: Some online lenders may be more open to helping you finance
immediate cash flow gaps. If you’re focusing on local banks, pay down debt before you
apply. Also, calculate your cash flow to understand your starting point before heading to
the bank.

3. Capital

What it is: The amount of money invested by the business

owner or management team.
Why it matters: Banks are more willing to lend to owners who
have invested some of their own money into the venture.
It shows you have some “skin in the game.”
How it’s assessed: From the amount of money the
borrower or management team has invested in the business.
How to master it: Nearly 60% of small-business owners use
personal savings to start their business, according to the Small Business
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4. Conditions

What it is: The condition of your business — whether it is growing or faltering — as well
as what you’ll use the funds for. It also considers the state of the economy, industry trends
and how these factors might affect your ability to repay the loan.
Why it matters: To ensure that loans are repaid, banks want to lend to businesses
operating under favorable conditions. They aim to identify risks and protect themselves
accordingly.
How it’s assessed: From a review of the
competitive landscape, supplier and customer
relationships, and macroeconomic and industry-
specific issues.
How to master it: You can’t control the economy,
but you can plan ahead. Although it might seem
counterintuitive, apply for a business line of
credit when your business is strong.

5. Collateral

What it is: Assets that are used to guarantee or

secure a loan.
Why it matters: Collateral is a backup source if
the borrower cannot repay a loan.
How it’s assessed: From hard assets such as real estate and equipment; working
capital, such as accounts receivable and inventory; and a borrower’s home that also can
be counted as collateral.
How to master it: Picking the right business structure can help protect your personal
assets from being seized by a lender if you’re sued or if a lender is trying to
collect. Forming a legal entity helps mitigate that risk.

ADVANTAGES OF CREDIT
Credit has its own advantages such as:
1. The use of goods and services as you pay for them. Just like
driving a car as you pay for it.
2. The opportunity to buy costly items that you might not be able to
buy with cash. Can you imagine paying cash for a brand new car?
3. A source of cash for emergency or unexpected expenses. A
person would always have a way to pay for emergency expenses—
like if your car breaks down or you have been hospitalized.
4. Convenience. It is easier and safer to have credit and you don’t
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Aside form advantages of credit, definitely it has its disadvantages on the part of the
borrower.
1. The Reduction of Future Income. The best example of this is spending future
income now and living beyond your income.

2. Expense. Using credit usually costs money.

It is automatically makes the item more
expensive than if you had just paid for it with cash
3. Temptation. In credit it is easy to spend
money you don’t/won’t have. You use credit to
live beyond your means—buying items you
simply can’t afford.

4. The Risk of Serious Consequences if you

Misuse Credit. Some of identified effect of misuse credit are,
failure to pay debts on time, bankruptcy, repossession and damaged to
credit score.

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