Chapter 1. The Nature of Credit
Chapter 1. The Nature of Credit
Chapter 1. The Nature of Credit
CHAPTER 1
THE NATURE OF CREDIT
Learning Objectives:
At the end of the chapter, the class should be able to understand the meaning of credit, internalize its
concepts, know its legal basis, become familiar with types of credits and evaluate credit risks.
What is credit?
Derived from the Latin word ‘credere’ which means to ‘believe or to trust’.
A legal agreement to receive cash, goods, or services now and pay for them in the
future.
It is based on the lender’s or creditor’s confidence in the borrower’s or debtor’s ability
to make payments in the future.
Credit is the power or ability to obtain money, goods or services at present time in
exchange for a promise to pay with money upon demand or at a determinable future
time.
1. The Creditor. The party that parts with present value in exchange for the other
party’s promise to pay for the same in the future, as promised.
2. The Debtor. The party that asks for and receive present value in the form of goods or
services from the creditor.
Foundations of credit
1. Trust and Confidence. Creditors must have absolute confidence in the
personal character and in the ability as well as the willingness of their debtors
to accept, honor and settle their obligations.
Characteristic of credit
1. Credit is a Bipartite Contract . Credit always involves two parties: the debtor
who obtains the money, goods or services in exchange of his promise to pay
at a future date; and the creditor who lends his money, goods or services for
the right to collect on demand or at a determinable future time.
Importance of credit
The law requires creditors to furnish each customer the following information before
the 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 the credit.
5. The total amount to be financed.
6. The finance charge 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.
Credit Risk
A credit risk is the amount of potential for default that is inherent in a given debt
investment or extension of credit. A lender or an investor in various types of bonds carries a
degree of credit risk on any transaction conducted. Assessing the degree of risk involved is
essential before completing any type of lending or investment transaction.
In determining credit risk, credit managers would have to assess the Cs of credit to
guide them in their daily business:
1. Character
Character is a quality of credit risk which 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. It is a quality inherent in an individual, making him conscientiously
concerned about his obligations.
The character of the borrower indicates his willingness to fulfill his financial
obligation, that is, to pay the loan as promised. While character does not in any way
indicate is probable ability to pay the loan, one who possesses good character will
always endeavor to meet his obligations.
2. Capacity
Capacity signifies the ability of a debtor to pay his obligations. A debtor may
be willing to pay his debt but may not have the cash with which to pay when it falls
due. The creditor must consider the age and health of the borrower.
The debtor’s capability include his ability to service the debt, replace the
assets as they wear out, provides money for living and possibly expansion which
requires liquidity. Being liquid means the availability of cash or the ability to generate
cash to meet ongoing commitments and expenses.
As one of the bases of credit capacity may be viewed from two senses:
b. Capacity may be looked upon as the ability to enter into a valid contract.
Age and health of the debtor are two important factors to consider. Unless
the individual is one of legal age, the contract may become invalid and
unenforceable. Thus, a contract between a credit-granting concern and a
minor is invalid. On the other hand, health is likewise another factor that
must be given important consideration. Uninterrupted earnings depend
largely upon one’s good health. Conversely, ill-health may make an
individual to suffer from a decrease in income that leads to impair his
ability to pay.
3. Capital
Capital is the financial strength of business. To the creditor, it is the guarantee
that a credit transaction entered can be redeemed. It can be determined by
deducting the total liabilities from the total assets. This is the net worth of the
business.
The risk factor increase with the length of loans, meaning to say, the longer
the term, the greater is the risk. It is for this reason, that in many instances, if not
always, most long term loans are secured by pledges of property.
4. Collateral
Collaterals are properties of value pledge to secure a loan. Loans secured by
immovable properties are called mortgage while loans secured by movable
properties are called chattel mortgage.
This is also referred to as security. As a borrower you do not want to give the
lender all your collateral if possible. This limits your ability to act without the lenders
blessing. This could limit your ability to make other borrowing decisions on your own
and reduce the speed by which you may need to take advantage of certain
situations.
5. Condition
Condition refers to the environment in the customer’s industry, economically,
legally and politically in relation to growth. The borrower has little or no control over
these external factors but they may have significant influence upon the appraisal of
credit risk.
Even if all criteria are passed, conditions may prevent a lender to forward a
loan. Conditions generally include markets, consumer trends, economic predictions
and as well environmental considerations.
Activity:
Develop an evaluation tool that could measure the 5 C’s of credit of a credit
applicant.
Part 1: Character Part 4: Collateral
Part 2: Capacity Part 5: Condition
Part 3: Capital
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The normal process of credit granting involves the following tasks or activities:
Sources of Credit
Banks are the most common sources of credit. Most of the commercial including
industrial and agricultural credits are obtained from the banks.
1. Retail stores are one of the biggest sources of personal credit. Sari-sari stores
give their customers credit on an open book account basis.
3. Credit unions are 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.
4. Individual money lenders are individuals who have excess funds and who
usually lend such funds to others who are in need. They charge exorbitant
interest for the use of money because of higher risk. They are also called loan
sharks.
5. Insurance companies are also sources of credit for policy holders. Such
individuals can borrow from the insurance company an amount that is allowed
by the insurance company.
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6. Sales finance companies are one of the biggest sources of consumer credit.
They also extend credit facilities to industrial, commercial, and agricultural
enterprises either by discounting or factoring commercial papers or accounts
receivables.
Credit Information
Using credit information from various sources is a basic and necessary part of every
good credit decision. The more information about a customer, the more reliable the
credit decision becomes.
1. The application form initiates the relationship between the debtor and the
creditor. It is the best source of data. Most often, it ranges from single page
information to as many as four to six pages.
2. Personal Interview - the customer is the cheapest and the easiest source
credit information. A direct contact with the customer enables you to assess
him personally. This allows you to ask precisely what you want to know. It is a
chance for you to verify the information contained in his application form.
8. Public and Published Records consist of all legal recordings such as deeds,
mortgage, suits, judgments, and current news items such as clippings from
newspapers and trade journals.
9. Credit Bureaus- the credit bureau distinguishes carefully between facts and
statements of opinion in order to make its reports reliable. The facts
contained in the report would help the creditors form their own opinion. The
credit bureau must also analyze the data in order to avoid shortcomings and
omissions and, if still necessary, gather more information. Such a review
would avoid possible derogatory information furnished by other sources.
Credit Rating
Standar
Moody's d& Fitch Credit worthiness
Poor's
An obligor has EXTREMELY STRONG capacity to meet its
Aaa AAA AAA
financial commitments.
Aa1 AA+ AA+
An obligor has VERY STRONG capacity to meet its
Aa2 AA AA financial commitments. It differs from the highest-rated
obligors only to a small degree.
Aa3 AA− AA−
A1 A+ A+ An obligor has STRONG capacity to meet its financial
commitments but is somewhat more susceptible to the
A2 A A
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A3 A− A−
adverse effects of changes in circumstances and
economic conditions than obligors in higher-rated
Baa1 BBB+ BBB+ An obligor has ADEQUATE capacity to meet its financial
commitments. However, adverse economic conditions or
Baa2 BBB BBB
changing circumstances are more likely to lead to a
weakened capacity of the obligor to meet its financial
Baa3 BBB− BBB−
commitments.
Ba1 BB+ BB+ An obligor is LESS VULNERABLE in the near term than
other lower-rated obligors. However, it faces major
Ba2 BB BB
ongoing uncertainties and exposure to adverse
business, financial, or economic conditions which could
Ba3 BB− BB− lead to the obligor's inadequate capacity to meet its
financial commitments.
B1 B+ B+ An obligor is MORE VULNERABLE than the obligors rated
'BB', but the obligor currently has the capacity to meet
B2 B B
its financial commitments. Adverse business, financial,
or economic conditions will likely impair the obligor's
B3 B− B− capacity or willingness to meet its financial
commitments.
An obligor is CURRENTLY VULNERABLE, and is
Caa CCC CCC dependent upon favorable business, financial, and
economic conditions to meet its financial commitments.
Ca CC CC An obligor is CURRENTLY HIGHLY-VULNERABLE.
The obligor is CURRENTLY HIGHLY-VULNERABLE to
C C nonpayment. May be used where a bankruptcy petition
has been filed.
An obligor has failed to pay one or more of its financial
C D D
obligations (rated or unrated) when it became due.
Preliminary ratings may be assigned to obligations
Expec pending receipt of final documentation and legal
e, p Pr
-ted opinions. The final rating may differ from the preliminary
rating.
Sound credit management principles revolve around three E’s , such as:
1. Estimation
b. For individuals who buy for consumption, character and their ability to pay
serve as important bases of credit; for business concerns, it is the net
worth and condition of the business as well as the reputation for paying
their bills.
2. Enforcement.
c. Collection records must be kept and maintained and should indicate when
notices were sent; dates when calls were made by collectors; payments
made; balances due and actions taken, if any.
3. Evaluation
3. Problem Solving Assistance. There are occasions when a debtor wants to pay
his debts but cannot do so because of problems. These problems may be
directly related with the debtor’s business or due to internal or external reasons
affecting his business and thus, his inability to pay.
In this case, you, as the creditor must always be ready and willing to offer
assistance to your debtor. Your success or failure in this aspect of collection
problem will have an impact on your long term relationship with the debtor. You
must not only be a good creditor in good times only but in bad times as well.
4. Coercion. Coercion must be applied only when really needed. Any form of
coercion must be valid and legal. When coercion is decided upon, apply it
promptly to its full extent.
Types of Debtors
This individual and others of his kind not infrequently pass sleepless nights
trying to find ways and means by which they could discharge their obligations
soon, if not soonest. Given time they do not constitute much of a problem to
bill collectors.
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In other instances, they are designed to serve as a smoke screen for their
failure to meet their obligations on time. Complaints may range from petty to
absurd, such as poor service on the part of the creditor company, defective
merchandise, to so-called “overpricing” of the goods and others.
3. The politician-type. This type of debtor does not deny the existence of his
obligation which arose from previous transactions of his. Neither does he
shun away from the presence of bill collectors.
However, like the politician, this type of debtor has a number of reasons kept
under his sleeves which explain one way or the other why he cannot pay on
time or should not pay at least for the time being. Hence, the necessity for
postponement in the settlement of the obligation.
As a practitioner of public relations, he makes the collectors feel that they are
welcome at his place. In fact, he has always a ready smile and a warm
handshake for the creditors or their bill collectors. In some instances, he
treats them with a cup of coffee or the like. No wonder, in a number of
instances, bill collectors return back to their offices empty handed since they
feel awed and thereby could not pursue their mission of collection for their
employers as with vigor and determination.
4. The uncooperative and indifferent debtor. This type of debtor does not
pay on time, not because he cannot pay but rather because he finds it
difficult to part with his money. The Tagalogs have a word for this kind of
individual. He is “makunat” which in English is synonymous with “stiff” or
hard.
Such type of debtors are not concerned with what society or their fellow-
beings think of them. Their reputation and names are at best secondary to
them. What is important to them is money which to their minds are the “be-
all” and “end-all” or everything in the society where they live.
5. Paranoiac. Some people feel on top of the world even when their world is
crumbling to pieces. They suffer from delusions of grandeur. Psychologists
call them as the paranoid.
they will settle their obligations although the question that remains
unresolved is: when?
Sometimes they claim that their secretaries are not around and so nobody
could prepare the check. This type of debtors need be made to feel
important and moreover put into good humor by inflating their egos in order
to induce them to pay soon, if not soonest.
7. The elusive type. Some debtors are as elusive as an eel. It is hard for bill
collectors to find them in their offices or in their homes.
Many of them maintain two doors, one to gain entry – and the other as an
exit without being detected by those who are waiting for them. They
generally leave their homes very early in the morning and come back late at
night. In the office, callers are screened for obvious reasons. For those who
can well afford, they are surrounded by cordon sanitaire.
They are rated as good, if not excellent risk. They continue to enjoy such
good rating until there is evidence which not only casts doubt on their credit
standing but proves the contrary.
1. Fair Credit
a. Careless borrower – merely needs reminding regularly
b. Complainer – he has grievances after he falls behind
c. Unforeseen problems – unemployment, shrunken income, medical
expenses
2. Slow Credit
a. Poor management of his finances, over indebtedness
b. Marital problems
c. Coward – afraid to face his creditors
3. No Good Credit
a. Lives beyond his income. Credit passed unknown.
b. Gypsy – in residence or employment
c. Crook – directly attempting to defraud
1. The negligent – he does not bother about due dates of his debts
2. The honest but confused – one who did not understand in the first place
the terms or conditions of the sale or debt/obligation he entered into.
5. Honest late payer – pays late because his own debtors also pay him late.
6. Chronically slow – a debtor who makes all creditors wait until they give
more liberal payment terms.
10.The tightrope walker – one who is usually on the verge of a financial crisis.
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11.The braggart – a debtor who almost always says “do you know who I am?”
and generally does not pay the debt unless put in an embarrassing situation
or threatened with a court suit.
12.The “vanishing” debtor – one who is not around come paying time, but is
always around when borrowing.