The Nature and Functions of

Credit
 CREDIT AND THE ECONOMY

 Although the availment of credit is often abused,

when used properly, it becomes a powerful means
of developing a person’s or a nation’s economic
potentials.
 Businesses which are short of capital may not be
able to produce at the most economic level of
quantity.
 The provision of credit to qualified individuals and
firms minimizes the ill-effects of the above-
mentioned scenarios.
 Credit is used heavily by even the most progressive
 What is Credit

 Credit may be defined as “the power or ability to obtain

goods or services in exchange for a promise to pay for
them later.
 ” The term “credit” refers to the power of the
prospective debtor rather than that of the creditor,
although that power will only be realized if the debtor is
accommodated by the creditor.
 When a credit agreement is consummated the amount
involved will be recorded as asset on the balance sheet
of the creditor and as liability on the balance sheet of
the debtor.
 CREDIT DISTINGUISHED FROM DEBT

 Credit refers to that power of a person to obtain goods or

service without the requirement of paying for them
immediately upon delivery.
 The credit power in the hands of a person may or may not be
used.
 When that power is used, the person who used it is now
obligated to pay a certain amount of money at a stipulated
date.
 That amount or any remaining portion of the original amount
is called debt.
 Simply stated, credit refers to power, while debt refers to
obligation.
 When credit is availed of, the result is debt.
 CREDIT DISTINGUISHED FROM CREDIT VOLUME

 A person who has a credit card with a credit limit of P30,000

will not be able to use the card for credit purchase higher
than P30,000.
 Thus, ten persons with a credit card limit each of P30,000 will
have an aggregate credit of P300,000.
 If one person decides to use his credit limit of P30,000 every
week and settles them promptly also every week, his total
credit availment per month will be P120,000 is referred to as
that person’s credit volume.
 As credit limit is fixed for a given period, credit volume may
increase or decrease from time to time.
 Thus, as the aggregate credit of ten persons may be
P300,000, their credit volume may be as low as zero or as
high as P3 million or even higher.
 The measurement of credit volume serves some purposes
when computed on a national scale.
 CREDIT DISTINGUISHED FROM WEALTH

 Although credit and wealth may be related in a way, these

two terms are different.
 Wealth refers to any materials or physical thing that satisfies
a human want, provided that it is limited in amount.
 Wealth includes the following residential building motor car
farm equipment books, watch, and jewelry.
 Credit on the other hand, is a means by which one may
acquire the right to use wealth.
 Credit does not increase wealth but it may be used to
increase wealth.
 When one acquires a farm equipment on credit, he uses it to
produce agricultural outputs like vegetables. He sells his
produce, settles his debts and the remaining amount is left
with him for his disposal.
 USERS OF CREDIT

Credit is used by the following general

groups:
 Consumers
 Business and
 Government
 Consumers

 Household consumption is oftentimes made possible

by purchases of goods and services on credit. The
following are examples of goods bought on credit by
consumers:
 house and lot
 motor vehicle
 household appliances
 educational services
 travel
 wedding expenses
 clothing and jewelry
 Business
Businesses are users of credit in large and
small amounts. It will be extremely difficult to
find a business big or small without debts of
some kind. Businesses avail of credit to
finance the following:
 payroll
 purchase of merchandise
 construction of building and facilities
 purchase of equipment
 refinancing of maturing debts
 Government

 The government is one big institution that uses credit in

big amounts.
 Borrowings made by the national government in 1998 from
foreign sources, for instance, reached $47.9 billion. By
June 30, 1999, the national government’s total debts
amounted to P1.593 trillion, consisting of P912 billion in
domestic debts and P681 billion in foreign debts.
 Even local government resort to borrowings when
expected revenues fall short of programmed expenditures.
 Borrowings are not the only form of government liabilities
however, other liabilities consist of unpaid obligations to
contractors and supplier, unpaid salaries and wages, rent
and others.
 KINDS OF CREDIT

1. consumer credit
2. trade credit
3. bank credit
4. investment credit
5. agricultural credit
6. export credit
7. public credit
 1. Consumer Credit

 Consumer credit refers to credit given by

shops, banks and other financial institutions
to consumers so that they can buy goods.
 Products and services that consumers can
buy on credit include food and groceries,
household appliances, automobiles, and
motorcycles, real estate, education, travel,
clothing, personal effects and others.
 Kinds of Consumer Credit

 charge account
 installment credit
 revolving charge account and
 personal loans.
 Charge Account
 Charge Account is “an arrangement which a
customer has with a store to buy goods and
to pay for them at a later date, usually when
the invoice is sent at the end of the month.
 ” Most sari-sari stores throughout the country
offer charge account services to customers.
 This is so because they are situated in
communities where store owners are
personally acquainted with most of its
residents in their respective areas.
 Installment Credit is an arrangement where the
customer buys goods by paying a sum regularly
each month.
 Revolving Charge Account is an arrangement
where, someone can purchase goods on credit at
any time up to an agreed amount, and continue
to purchase on credit while still paying off the
original, credit grant. The arrangement can also
be applied when borrowing from a bank.
 Personal Loan is a loan to a person for
household or other personal use not for business
use.
 2. Trade Credit

 Trade Credit is a credit offered by a company

when trading with another.
 When a cement manufacturer allows a dealer
60 days allowance for payment of goods
delivered to him, the manufacturer is
extending trade credit.
 Trade credit appears in the book of accounts
of the creditor as accounts or notes
receivable. On the book of the debtor, they
are entered as accounts or notes payable.
 Instruments of Trade Credit.

In extending trade credit, various means

are used. They are as follows:
(1) open-book credit,
(2) trade acceptance, and
(3) promissory note.
 (1) Open-Book Credit constitute the bulk of
trade credit. It is unsecured and it permits
the customer to pay for goods delivered to
him in a specified number of days.
 (2) Trade Acceptance is a time draft drawn
by a seller upon a purchaser payable to the
seller as payee, and accepted by the
purchaser as evidence that the goods
shipped are satisfactory and that the price is
due and payable.
(3) Promissory Note is an unconditional
promise in writing made by one
person to another, signed by the maker,
engaging to pay, on demand or at a
fixed or determinable future time, a sum
certain in money to, or to the order of a
specified person, or to the bearer.
 3.Bank Credit

Bank refers to all types of lending granted by the

banks to others or to one another. Among the
types of loans availed of by borrowers from banks
are:
1. commercial loans
2. real estate loans
3. agricultural loans
4. industrial loans
Among the types of loans availed of
by borrowers from banks are:

5. salary loans
6. automotive loans
7. deposits collateral loans
8. interbank call loans.
 4. Investment Credit

 Providers of credit are not normally interested in extending loans for

purposes of acquiring capital assets like plant and equipment.
 This is so because the returns on investment in capital assets may be
expected only after a good number of years. Hence, the liquidation of
the loan cannot be made immediately.
 The provision of credit for investment purposes is necessary if some
economic and business activities must be pursued.
 Investment credit refers to that type of credit required by businesses
and the government to finance the construction and operation of
certain projects. Proceeds of the investment credit are used for the
fixed and working capital of businesses for projects undertaken by local
provincial and the national government and for the purchase and
improvement of real estate.
 An example of investment credit is the plan of the World Bank Group
and the International Finance Corporation to allot within the next 4
years $4.2 billion in concessional loans and investments to the
Philippine government.
 Of the total credit, the World Bank will lend $3.2 billion to finance the
 5. Agricultural Credit

 Agricultural Credit is a very important feature of the Philippine

economy. This so because food production is a major activity of our
nation. The need to produce more food is made more urgent by the
rapidly increasing population. Since land is a limited commodity,
improvements in agricultural production can only be made by providing
the farmers with the financial capability to make their farms more
productive.
 Agricultural credit refers to loans used to finance the production and
marketing of agricultural products. This includes the lending of funds
for the purchase of farm equipment and machinery, fertilizers,
pesticides, seedlings, fingerlings and others.
 To provide funds in support of agriculture, the Agricultural
Competitiveness Enhancement Fund was created by the
government in 1996 for irrigation, farm-t-market roads, post- harvest
facilities, credit, research and development, retraining, extension
services and marketing infrastructure.
 The granting of ACEF agricultural credit will be coursed through
 6. Export Credit

 Export Credit refers to credit extension

provided to foreign buyers of local goods.
Even if prepayments by foreign buyers are
preferred by exporters, credit extension is
often requested by the buyer.
The various ways of extending credit
to foreign buyers are as follows:
 letter of credit
 documentary bills
 open account
 Letter of Credit
is a document issued by bank on behalf of a
customer (the foreign buyer) authorizing payment to
a supplier when the conditions specified in the
document are met.
 Documentary Bill
is mode used by an exporter willing to ship the
goods even before there is an assurance of payment.
The instrument used is the bill of exchange or draft.
 Open Account
is a method of extending credit to the foreign buyer
wherein goods are sent and which are billed later at
regular intervals.
 7. Public Credit

 Public Credit refers to loans extended to the

government whether at the national, provincial,
or municipal level.
 Borrowings by the government are used to
finance operations when expected revenues are
not sufficient to cover expenditures.
 The government uses various means to avail of
credit provided by various sources. The credit
instruments to avail of credit consist of bills,
notes, and bonds.
 BASIS OF CREDIT

Even if an individual or an institution is in dire need of

funds, goods, or services, they may not be granted
credit.
The usual requirements for credit approval are
focused on whether or not the individual or institution
requiring credit will quality according to the standards
set using the following criteria:
 character
 capacity
 capital
 condition
 collateral
 Character as a Basis of Credit

 When character is used as a basis of credit, the lender

wants to make sure of the borrower’s honesty,
responsibility, integrity, and consistency. These
characteristics may be indicated in some ways which
include the following:
1.complaints and legal actions filed with the courts
which provide clues to a person’s or a business firm’s
honesty.
2. Past credit record with lenders.
 When all relevant information is gathered, the lender will
be in position to make a conclusion on a borrower’s
willingness to pay.
 Capacity as a Basis of Credit

 As the lender must be convinced that the borrowed amount

will be paid back, the borrower’s ability to pay must be
established.
 That ability called capacity and may be determined by using
information on current expected income existing debts, and
current operating expenses of the borrower.
 Useful sources of information regarding capacity consist of
current and projected financial statements.
 In computing expected income, the use of probability
estimates will be of help.
 Under this approach, the likelihood that an expected income
will be realized is considered as a result, adjustments in
expected income may be made.
 Capital as a Basis of Credit

 A borrower’s capital may be used as a source of

fund to pay debts when the borrower’s capacity is
impaired.
 Capital is computed by deducting liabilities from
assets. The borrower’s capital will serve the
settlement of debts.
 It follows that a borrower who has more capita in a
better financial position and this will be a plus
factor in the granting credit.
 Collateral as a Basis of Credit

 A collateral is “a valuable asset pledge against a loan”,

which will be forfeited if the loan is not repaid or which will
be returned intact upon loan repayment.
 Lenders oftentimes, require collateral before a loan is
granted.
 The collateral strengthens the resolve of the borrower to
repay the loan.
 Most lenders will only accept collaterals with higher values
than the amount loaned.
 The difference in the amounts is the computed allowance for
changes in the liquidation value of the collateral.
 The lender is provided with a cushion for unexpected
changes in values of the collaterals.
 Condition as a Basis of Credit
 The creditor may determine that the prospective
borrower has the capacity to pay his debts.
 This capacity however, may be seriously impaired
when negative developments in the economy appear.
 It is already widely known that certain economic and
business pursuits can only be successful under
favorable conditions.
 This means that when conditions change, the
viability (and the paying capacity) of an enterprise
or individual will be seriously affected.
 It is therefore, important that in determining
whether or not credit will be granted the business
and economic conditions affecting the prospective
 Sources of Credit Information

In determining the credit rating of a

prospective borrower, various source of
information may be availed of. These are
the following:
 Interview with the applicant
 Credit rating agencies
 Lender’s own records
 Financial statements
 Interview with the Applicant

 In the borrowing process, the loan applicant is

normally required to accomplish a loan application.
 This document contains important basic information
about the applicant.
 With the use of the application, the credit evaluator
will be able to form some opinion about the credit
worthiness of the applicant.
 If the evaluator wants to validate his initial
impressions, he will call for an interview with the
applicant.
 In the interview, the evaluator may get a glimpse of
the applicant’s honesty and ability.
Also, the following information may be
derived:
 the history and growth of the applicant’s
business;
 the backgrounds of the key personnel of the
business;
 the nature of the products and services handled;
 the sources of raw materials or stocks of
merchandise;
 competitive position of the business; and
 plans for the future.
 Credit Rating Agencies:

 A credit rating agency is a company which

report on the credit worthiness of customers to
show whether they should be allowed credit. In
the Philippines, there are agencies which
provide credit information to interested parties.
 Example are provided as follows:
 Adiova, Nancy – a firm which sells credit
information services, with office at VW
Castillo Bldg. Pasay City, M.M.
 BAP Credit Bureau, Inc. – a firm
established by the Bankers Association of
the Philippines to facilitate the exchange of
credit information among member banks.
 To serve the needs of users of credit reports throughout the
world, credit agencies may be found in many countries.

 Top Ten Credit Rating Agencies of the World

1. Moody’s – the oldest credit rating agency based in USA and serves 40% of
the world’s credit rating market.
2. Standard and Poor’s – is an American financial services company. It is
owned by McGraw-Hill, Inc. and is considered one of the Big Three credit-
rating agencies in the world.
3. Fitch – founded in New York City in 1913 and is jointly owned by Hearst
Corporation and FIMALAC SA. Its two headquarters are located in New York
City and London.
4. DBRS a credit rating agency founded in 1976 in Toronto. It is the largest
rating agency in Canada with other officers in New York, Chicago and
London. It has about 2.5% global market share.
 Top Ten Credit Rating Agencies of the World

5. Egan Jones – a Philadelphia based agency founded in 1995. It rates

over 2,000 high-grade and high-yield US corporate debt issues.
6. A.M. Best – founded in 1899 and it is the main agency used for
insurance companies.
7. Japan Credit Rating Agency, Ltd. – the main credit rating agency in
Japan, established in 1985.
8. Rating and Investment Information, Inc. – a Japanese credit rating
agency established in 1975, with capitalization of 590 million yen.
9. Lace Financial Corporation – a U.S. based company founded
company founded in 1984. It provides financial ratings on 9,000
commercial and savings banks; 1,400 bank holding companies, 1,100
savings and loans, 1,500 to 12,000 credit unions and 100 title
insurance companies.
10. Real point – a privately held limited liability company founded in
2001 and is based in Pennsylvania, U.S.A. They company specializes
in structured finance market.
 Lender’s Own Records

 There are times when a supplier of goods does

business with a buy for an extended period.
 This may be enough for the buyer to establish
reputation as a responsible client.
 This experience may be used by the supplier as
a basis for extending credit to the buyer.
 Provider of credit must have records of their
good customers.
 These records will serve as a handy source of
credit information whenever they a needed.
 Financial Statements

 Financial statements, consisting of the Balance Sheet,

Income Statements, Statement of Cash Flows and
Statement of Changes in Equity are useful sources of
credit information.
 These are required for submission by prospective borrowers
especially if the amount involved is large.
 Even if the amount borrowed is small, the credit applicant is
required to furnish some information regarding his income
expenses, properties owned and liabilities.
 As financial statements are documents indicating the
financial condition of any enterprise or individual.
 When properly analyzed, they provide very reliable means of
credit evaluation.
 Types of Financial Statements

 Statement of Financial Position

 Statement of Comprehensive Income
 Statement of Changes in Equity
 Statement of Cash Flows
 Statement of Financial Position

 Statement of Financial Position also

known as the Balance sheet gives the
understanding to its users about the
financial status of the business at the
particular point of time by showing the
details of the assets of the company along
with its liabilities and owner’s capital.
 Three important elements SFP
 Assets which are the resources owned and controlled
by the business. Assets are further 
classified into Current Assets and Non-Current Assets.
 Liabilities which are the amount business owed to its
Lenders and Other Creditors. Liabilities are further 
classified into Current Liabilities and 
Long Term Liabilities.
 Shareholder’s Equity which is the residual Interest
in the Net Assets of a business that remains after
deducting its liabilities  
 Statement of Comprehensive Income

 Statement of Comprehensive Income is a financial

performance statement that listed down all profit and loss
and other comprehensive income of entity for the period of
time.
 A statement of comprehensive income differs from a
typical income statement, which details profits and
losses, but may omit changes in net assets due to transfer
of equity holdings, change of ownership, or other factors.
 Statement of Comprehensive Income records both
operating profit and loss and other comprehensive income
which is not from normal operating activities.
 Statement of Cash Flows

 The statement of cash flows reports the

sources and uses of cash by operating
activities, investing activities, financing
activities, and certain supplemental
information for the period specified in
the heading of the statement. The
statement of cash flows is also known as
the cash flow statement.
 Primary purpose of the statement of
cash flows 
 The primary purpose of the statement of cash
flows is to provide information
about cash receipts, cash payments, and the net
change in cash resulting from the operating,
investing, and financing activities of a company
during the period.
 Statement of Changes in Equity

 Statement of Changes in Equity,

often referred to as Statement of
Retained, details the change in
owners' equity over an accounting
period by presenting the movement
in reserves comprising the
shareholders' equity.
 Movement in shareholders' equity over an
accounting period comprises the following
elements:

 Net profit or loss during the accounting period

attributable to shareholders
 Increase or decrease in share capital reserves
 Dividend payments to shareholders
 Gains and losses recognized directly in equity
 Effect of changes in accounting policies
 Effect of correction of prior period error