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Basic Finance
Basic Finance
Viewing banking theory as an element in general economic theory, the reason for
the development of banking as a mechanism likewise becomes plain. It is the
outcome of the experience of other methods of exchange. In the early history of
civilization, there was a long period during which the principal exchanges were
effected by means of barter. This period was followed by another during which
money exchanges came in to supersede barter to a very considerable extent. Within
comparatively modern times a credit systemhas succeeded the systems of ancient
and mediaeval times. It should not be understood from what has been said that
these periods of barter, money, and credit exchange are sharply marked off from
one another, or even that they shade into one another by imperceptible degrees. On
the contrary, the facts in the case seem to show that there was extensive
overlapping, and that fairly advanced ideas of credit were developed quite early in
the period of money exchanges, while barter, as is well known, has persisted in
many parts of the world down to modern times and has even been broadened and
confirmed since the close of the European war because of the inadequacy of the
money and credit systems of Europe, as seen in the shipment of materials from the
United States to Europe and the return of finished goods made from such materials
in payment therefor. There are thus no distinct "periods," in the chronological
sense, which may be marked off from one another as indicating the duration of the
systems of barter, money, or credit. It is possible to speak of "periods" in this
connection only in the sense that the predominant characteristic or controlling
method of exchange employed at any given time may be said to have been that of
either barter, money, or credit. Speaking in this restricted sense, it is fair to regard
the sixteenth century as a period characterized by a wide use of money, while the
nineteenth century and the beginning of the twentieth, particularly the years after
1850, was essentially a credit period, and accordingly a period in which banking
was brought to a development which had previously not been known.
b. Elements of credit
Debt History
One of the main factors that goes into a person's creditworthiness is his history of
paying back -- or not paying back -- loans in the past. Credit reporting bureaus, as
well as most lenders, consider a borrower's past actions a strong indication of what
he will do in the future. If a person has a history of defaults, he will be considered
a far higher risk than a person with a clean record of on-time paybacks.
Income
Current Debt
A lender must also look at the number of loans that a person currently has out. It a
person has a large number of loans out right now, then he may be at a higher risk of
default, as any lender who offers him a new loan may be last in line to be paid
back. Therefore, people who don't have any outstanding loans generally have better
credit than people who do.
Collateral
Finally, loans can be split into two main types -- secured and unsecured. A secured
loan is a loan that is backed by some form of collateral, an asset that the lender can
seize in the event that the borrower defaults. Unsecured loans are loans that are not
backed by collateral. Generally, secured loans command less interest because the
lender is more likely to be compensated.
We often hear that Business enterprises avails credit facilities in the form of Cash
Credit and Term Loans from Banking system in order to meet the funding
requirements of the business for their day-to-day operations and Capex plans. The
basic concepts of the LOAN and MANAGING THE FUND FLOW remain the
same whether it is for an individual or a business enterprise. Let us go through the
following to have deeper understanding:- Assuming a person X earns a net salary
of Rs.50000/- per month. He incurs family expenses of Rs.40000/- per month in
the form of say Rent, Household expenses, Medical expenses, School Fees,
Conveyance, Telephone and other Maintenance expenses. The surplus available is
Rs.10000/ p.m translating into the annual savings of Rs.1,20,000/- This is nothing
but retained profits from his salary savings. a. In case of X incurs additional
expenses say during festive seasons or to meet medical expenses to the tune of
Rs.20000/- on a particular month - what he will do? b. In case of X wants to
purchase Washing Machine, Refrigerator, New television Set etc., to the tune of
Rs.50000/- on a particular month what he will do? c. In case X buys a property
beyond his means viz., raising short term finance, loan from private financier?
what will happen? There are two possibilities in the first case (a) If he utilizes
the expenses out of monthly savings, he will not end up in any shortage of
cash/funds to meet the additional expenses. In case, the surplus is earmarked for
some other commitment say Mutual funds or Insurance, he can meet the expenses
thro a - CREDIT CARD This is nothing but a working capital facility This
can be paid off in the next 2 months surplus or savings from the monthly
expenses So long as Mr. X utilizes the Credit Card prudently, he will not have
any difficulties in meeting the expenses. In the second case, there are three
possibilities Mr. X spends about Rs.30000/- for purchase of the said equipment
out of the monthly salary The eventuality will be, he may end up in not having
enough funds to meet the day to day expenses - (This is nothing but meeting the
expenses of Fixed assets out of working capital- To be avoided) Mr. X takes
consumer loan or employee loan of Rs.50000/- for a period of 24 months from his
employer instead of utilizing the major portion of his monthly Salary. This is the
ideal way of meeting the requirement so that he will not face any difficulty in
meeting the day-to-day expenses as also the EMI repayment of consumer loan.
(Funding by way of term loan to meet the expenses of fixed assets is advisable)
Mr. X meets the expenses of buying the assets out of monthly savings at the end
of 6th month or 12th month (as the case may be), he will not face any difficulties
(he meets the expenses of fixed assets out of retained savings /surplus which is
nothing but his Capital funds) In the third case, Mr. X will have severe financial
liquidity problems and miss-managing the funds. Will end up in defaulting the
payments towards day-to-day expenses. Ideally, he should not have gone for
purchase of property when he does not have adequate repayment capacity. He
should have planned his funds in such a way that he meets the requirements by
paying 20% of the amount through savings and 80% by way of long term loans say
for 15 years or 20 years Similarly the above concepts are being practiced in the
form of Cash Credit and Term loans when comes to funding requirements of a
business enterprise be it partnership firm or proprietary concern or company.
We often hear the case of default by a business enterprise. Reason is the same as
explained from the view point of an individual. a. Meeting the long term
requirements out of working capital facility b. Does not have adequate profits
/internal accruals to meet the capital expenditure plans. c. Acquires property
/fixed assets without proper financial tie-up. The principles of managing the funds
remain the same. Basic concepts needs proper understanding before appraising the
requirement of a business enterprises. There are other factors which play vital role
in ensuring the repayment of loans Business model, ability of the promoters to
run the business in an effective manner and integrity of the promoters.
d. Functions of credit
In most cases credit usually costs money, in the form of interest or other
fees. This adds to the total cost of the item.
It can be tempting to overspend. Instead of comparison shopping for the best
price, you save time and purchase it now. You should keep track of your
spending each month to ensure that you can repay a credit card in full when it
comes due each month.
Overuse of credit can lead to a poor credit record.
Buying on credit can be habit forming.
a. characteristic of credit
Character
Sometimes called credit history, the first C refers to a borrower's reputation or
track record for repaying debts. This information appears on the borrower's credit
reports. Generated by the three major credit bureaus Experian, TransUnion and
Equifax credit reports contain detailed information about how much an applicant
has borrowed in the past and whether he has repaid his loans on time. These reports
also contain information on collection accounts, judgments, liens and bankruptcies,
and they retain most information for seven years. The Fair Isaac Corporation
(FICO) uses this information to create a credit score, a tool lenders use to get a
quick snapshot of creditworthiness before looking at credit reports.
Capacity
Capacity measures a borrower's ability to repay a loan by comparing income
against recurring debtsand assessing the borrower's debt-to-income (DTI) ratio. In
addition to examining income, lenders look at the length of time an applicant has
been at his job and job stability.
Capital
Lenders also consider any capital the borrower puts toward a potential investment.
A large contribution by the borrower decreases the chance of default. For example,
borrowers who have a down payment for a home typically find it easier to get a
mortgage. Even special mortgages designed to make homeownership accessible to
more people, such as loans guaranteed by the Federal Housing Authority (FHA)
and the Veterans Administration (VA), require borrowers to put between 2 and
3.5% down on their homes. Down payments indicate the borrower's level of
seriousness, which can make lenders more comfortable in extending credit.
Collateral
Collateral can help a borrower secure loans. It gives the lender the assurance that if
the borrower defaults on the loan, the lender can repossess the collateral. For
example, car loans are secured by cars, and mortgages are secured by homes.
Conditions
The conditions of the loan, such as its interest rate and amount of principal,
influence the lender's desire to finance the borrower. Conditions refer to how a
borrower intends to use the money. For example, if a borrower applies for a car
loan or a home improvement loan, a lender may be more likely to approve those
loans because of their specific purpose, rather than a signature loan that could be
used for anything.
For more on the five C's, find out why banks use the five C's of credit to determine
a borrower's creditworthiness.
b. foundation of credit
c. sources of credit