MONEY AND CREDIT

TOPIC 6. CREDIT

Content units:
6.1. Concept and elements of credit.
6.2. Types of credit.
Didactic goals:
define basic terminology used when discussing credit activity;
list the elements of the credit relationships;
explain thew diference between different types of credit.
Key words: credit, commercial credit, banking credit
 6.1. Concept and elements of credit

Credit is a contractual agreement in which a borrower receives

something of value immediately and agrees to pay for it later, usually with
interest.
Credit is the arrangement where the borrower receives the money from the
lender and, in turn, agrees to pay the interest for the period during which
money is held with the borrower and promises to repay after a predetermined
time.
Credit is of many types, and some of the examples include mortgage
loans, letters of credit, bank guarantees, consumer credit, trade credit, etc.
Bank-issued credit makes up the largest proportion of credit in existence.
Bank credit is usually referred to as a loan given for business
requirements or personal needs to its customers, with or without a guarantee
or collateral, with an expectation of earning periodic interest on the loan
amount. The principal amount is refunded at the end of loan tenure, duly
agreed upon, and mentioned in the loan covenant.
 6.1. Concept and elements of credit

The following are characteristics of bank credit:

- Borrower: Person who borrows money.
- Lender: The person who lends money is usually the bank.
- Principal is the original borrowed amount that should be returned.
- Rate of Interest is the cost of borrowing the money. The interest rate
can be fixed or floating rate of interest. The floating interest rate is often
based on international benchmark rates like LIBOR.
- Term of Repayment is the period from the starting point of credit to
the final maturity of a transaction. These are mentioned in the loan
covenant.
- Mode of Loan: Normally given in cash but sometimes will be given
in the form of raw material or fixed assets.
- Credit risk is the possibility of a loss resulting from a borrower's
failure to repay a loan or meet contractual obligations. Traditionally, it
refers to the risk that a lender may not receive the owed principal and
interest, which results in an interruption of cash flows and increased costs
for collection.
 6.1. Concept and elements of credit
Lenders customarily analyze the credit worthiness of the borrower by using the Five
C’s: capacity, capital, collateral, conditions, and character. Each of these criteria helps the
lender to determine the overall risk of the loan:
1. Capacity. Capacity examines whether the borrower has the capacity or ability to
repay. This is the most important and defining C of Credit. Capacity is evaluated by
several components, including the following:
- Cash Flow refers to the income a business generates versus the expenses it takes to run
the business analyzed over a specific time period-usually two or three years. If the
business is a start up, prepare a monthly cash flow statement for Year 1.
- Payment history refers to the timeliness of the payments that have been made on
previous loans. Today there are companies that evaluate commercial credit ratings (such
as Dun & Bradstreet) that are able to provide this kind of history to lenders.
- Contingent sources for repayment are additional sources of income that can be used to
repay a loan. These could include personal assets, savings or checking accounts, and other
resources that might be used. For small businesses, the income of a spouse employed
outside the business is commonly considered.
 6.1. Concept and elements of credit
2. Character.
This is a highly subjective evaluation of the business owner’s personal history.
Lenders have to believe that a business owner is a reliable individual who can be
depended on to repay the loan.
Background characteristics such as personal credit history, education, and work
experience are all factors in this business credit analysis.
Character is the single most important factor considered by a reputable bank. Banks
want to do business with people who are honest, ethical and fair. (The difference between
the ability to repay a loan and the willingness to repay a loan is an example of a person’s
character.)
The knowledge, skills, and abilities of the owner and management team are vital
components of this credit factor.
 6.1. Concept and elements of credit

3. Collateral. Collateral is the secondary source of repayment; it

pledges other assets against the loan in case the primary source of
repayment (cash flow) fails. Sound credit policies and procedures require all
loans to have a secondary source of repayment; a back-up plan to minimize
the risk.
Machinery, accounts receivable, inventory, and other business assets that
can be sold if a borrower fails to repay the loan are considered collateral.
Since small items such as computers and office equipment are not
typically considered collateral, in the case of most small business loans, the
owner’s personal assets (such as his/her home or automobile) are required in
order for the loan to be approved.
When an owner of a small business uses his/her personal assets as a
guarantee on a business loan, that means the lender can sell those personal
items to satisfy any outstanding amount that is not repaid.
 6.1. Concept and elements of credit

4. Capital. A company’s owner must have his own funds invested in

the company before a financial institution will be willing to risk their
investment.
Capital is the owner’s personal investment in his/her business which
could be lost if the business fails.
There is no fixed amount or percentage that the owner must be vested in
his/her own company before he is eligible for a business loan.
However, most lenders want to see at least 25% of a company’s funding
coming from the owner.
 6.1. Concept and elements of credit
5. Conditions. This is an overall evaluation of the general economic.
Economic conditions specific to the industry of the business applying for the loan
as well as the overall state of the country’s economy factor heavily into a decision to
approve a loan.
Clearly, if a company is a thriving industry during a time of economic growth,
there is more of a chance that the loan will be granted than if the industry is
declining and the economy is uncertain.
The purpose of the loan is an important factor. If a company plans to invest the
loan into business by acquiring assets or expanding its market, there is more of a
chance of approval than if it plans to use the fund for more expenses.
Typical factors included in this evaluation step include: the strength and number of
competitors, size and attractiveness of the market, dependence on changes in
consumer tastes and preferences, customer or supplier concentration, length of time
in business, and any relevant social, economic, or political forces that could impact
the business.
 6.1. Concept and elements of credit

The additional Cs are:

6. Compliance. Compliance measures whether or not the credit request is in
compliance with state regulations, and is consistent with the institution’s
business plan.
7. Cost-benefit analysis. Cost-benefit measures whether or not the financial
institution (bank) is being adequately compensated for the contemplated
risk? Are existed risk adequately priced?
 6.2. Types of credit

Credit is not one homogeneous good or asset.

It is of various kinds. To understand better the nature, scope and
complexity of credit and its problems, we look at the several kinds of
credit.
There is no unique way of classifying credit. It can be, and need to be,
classified in more than one way, each way specializing in only one
aspect or dimension of credit.
 6.2. Types of credit

There are different types of credit, classified based on different criteria’s.

1. Classification based on the borrower.
- Loan for Personal Purpose. Personal loans are given to meet the particular needs of
the group and individual. For example, personal loans are taken to purchase
consumer goods, electronics, houses, vehicles, etc.
- Loan for Business or Profession Purposes. These loans are offered to meet the
needs of the business. It can be a working capital loan or cash credit facility to meet
a short-term liquidity crunch. Companies borrow money for major fixed asset
expansion, business diversification into different product portfolios, and varied
customer segments. The purpose of lending money will be different for different
businesses based on circumstances, needs, and environments in which the company
operates.
 6.2. Types of credit

2. Classification based on security

- Secured loans are secured against collateral, a guarantee given to the Bank by the
third party. Loans can be secured against property, plant and machinery and
equipment, debtors, stock, fixed deposits, and any other asset which can be sold or
liquidated by the Bank in case of nonpayment of installment on the part of the
borrower.
Bank will also lend money against the guarantee given by the third party on behalf of
the borrower. In the case of a guarantee, the guarantor will be liable to pay a
balanced amount if the borrower fails to do so.
- Unsecured loans are neither secured against any asset nor any guarantee is provided
to the Bank. A borrower with a great history of the settlement of dues, good credit
rating, and sound financial records will generally get an unsecured loan.
 6.2. Types of credit

3. Classification based on duration

- Short Term Loans. These loans are given for a shorter duration, say one month to
one year (Credit Card Loans, Cash Credit Facility or Bank Overdraft Facility,
Working Capital Loans);
- Medium term loans;
- Long Term Loans. These loans are given for longer, say three to five years or more
than that. These loans are provided for the expansion of business, diversification of
product portfolio or business, substantial investment in fixed assets, and real estate
where the cost to buy such assets or investments is so vast that repayment of the
same within a year is not possible.
 6.2. Types of credit

4. Classification based on Purpose of Bank Credit

- Trade Credit refers to credit in business dealings like selling goods on credit where
the customer promises to pay money later, buying goods on credit where we, the
customer of the supplier, promise to pay to the supplier on a later date.
- Agricultural credit includes the promises to pay of farmers and farm organizations.
- Investment credit- the promise to pay of individuals or business firms.
- Industrial credit;
- Export credit;
- Consumer Credit refers to money, goods, or services provided on the agreement
with the consumer to pay later with the charges for using the credit. Consumer
credit is specifically designed for consumers to give them various benefits.
Consumer credit involves Educational Loans, Housing Loans, Vehicle Loans,
personal loans etc.
 6.2. Types of credit

5. Classification based on the method of issuing a loan and the procedure for its
repayment:
- Revolving credit involves the continuous credit in which the lender gives the
extension of credit to the borrower so long as the account is regular and open by
regular payments like in case of credit card the credit is given regularly and limit of
credit is given and payment to be made on monthly or quarterly basis. And the
account will continue till it is closed, i.e., credit is extended every month.
A line of credit is one type of credit that comes with a capped limit and can be used up
until you reach the predetermined threshold. It may include regular minimum
payments, but usually, there is not a fixed repayment schedule.
 6.2. Types of credit

- Installment loans are another type of credit that includes a fixed payment schedule
for a specified duration. An example of an installment loan would be a car loan —
you are required to pay a set amount of money at a recurring interval (ex. $280 per
month) until the loan is paid off in full. Other examples include mortgages, student
loans, and term loans.
- Open credit is a type of credit that requires full payment for each period, such as per
month. You can borrow up to a maximum amount, similar to a credit card limit, but
you are required to pay the funds borrowed in full at the end of each period. An
example of this would be a cellphone bill — you can make phone calls, send text
messages, and use data each month, and at the end of the month, you are required
to pay for the services you used (including any additional usage fees). Another
example would be a utility bill (such as electricity usage in your household, gas
bills etc).
6.2. Types of credit
6.2. Types of credit
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