FIMA 205: Understanding Credit Principles

• FIMA 205 covers credit and collection.

Overview of Credit

• Credit is the ability to obtain valuable items in exchange for a promise to pay at a future time from the debtor's perspective.
• Credit represents a creditor's willingness to accept a debtor's promise based on trust and confidence.
• Credit plays a crucial role in today's economy, influencing communities' physical appearance, lifestyle, and living standards.
• The extent of credit use indicates a country's political, economic, and social status.
• Credit allows for production and helps businesses expand when market opportunities arise and forecast profitability.
• Credit provides financial resources for businessmen to capitalize on market opportunities domestically and internationally.
• Governmental and private efforts to promote full employment depend on the increase in goods and services production, influenced by businessmen's market expectations and consumer ability to fulfill desires.
• Consumer credit links production and distribution, enabling consumers to purchase goods beyond their immediate means.

Elements of Credit

• Trust is vital when granting credit.
• Futurity is an element of credit involving time.
• Risk exists because the creditor depends on the debtor's future performance, with uncertainty in payment or possible payment reduction.

Characteristics of Credit

• Credit is a two-party (bilateral) contract between a debtor and a creditor.
• A creditor shows faith by transferring goods or services ownership based on the debtor's promise to pay later.
• The debtor commits to payment and acknowledges the creditor's right to collect the price.
• Debtor's character and repayment ability is important when extending a loan
• Debt obligations and claims are denominated using a reliable standard of deferred payments, specifically money.

Credit Transactions

• Credit transactions arise for deferred payments for goods/services.
• Credit transactions arise for money loans.
• Credit transactions arise for services rendered.

Advantages of Credit

• Credit allows usage of goods and services immediately with deferred payment.
• Credit is especially helpful for big-ticket items.
• Credit cards provide shopping convenience without carrying large amounts of cash.
• Credit can provide temporary financial solution.
• Credit channels idle funds into productive activities through bank lending.
• Credit increases wealth liquidity through secured loans that convert fixed assets into current ones.
• Credit supplements the monetary system through checks.

Disadvantages of Credit

• Credit costs money.
• Purchases paid over time cost more than cash.
• Credit encourages overspending.
• Consumers easily acquire debt buying items.
• Credit ties up future income.
• Purchases result in less disposable income.
• Failure to make payments may result in loss of merchandise or collateral.
• Liberal credit leads to over-expansion or speculation.
• Governments borrowing heavily may curtail necessary projects.

Classifications and Kinds of Credit

• Time Loan is payable on a specific date.
• Short-term is payable within a year.
• Medium-term is payable in one to five years.
• Long-term is payable in more than five years.
• Call/Demand Loan is payable on demand.
• Public credit is issued by government.
• Private credit is issued by financial institutions.
• Ordinary interest is paid with principal on the due date.
• Discount interest is deducted from the principal upon granting the loan.
• Lump-sum principal is paid in full.
• Installment principal is released or repaid in staggered amounts.
• Self-liquidating repayment comes from asset.
• Non-self-liquidating repayment comes from income of debtor.
• Agricultural credit finances agricultural needs.
• Commercial credit finances short-term capital needs.
• Industrial credit finances long-term capital needs.
• Real estate is used to finance property acquisition.
• Personal or consumer credit facilitates consumption.
• Secured credit is issued with collateral.
• Unsecured credit is issued with good faith.

Loan Considerations

• It is important that the purpose of the loan be productive and beneficial to the community.
• Diversify the loan portfolio to spread lending risks, considering the amount involved.
• Loan maturity should align with the duration of borrower's financing needs.
• Collateral, like real estate, should be required mitigate lending risks
• Interest rates depend on factors like funding costs and account relationship.

The Ten Commandments of Credit: The Cs of Good and Bad Loans

• The five Cs of credit should be reviewed by examiners and lenders.
• The 5 Cs are character, capacity, conditions, capital and collateral.
• Character assesses borrower's payment habits/willingness to pay.
• Capacity refers to borrower's payment ability via cash flows.
• Capital is borrower's net worth.
• Collateral is asset pledged against debt.
• Economic conditions influence the borrower's industry and ability.
• Lack of clear credit quality objectives can cause issues.
• Upward communication is when frontline employees escalate issues up the chain of command.
• Poor communication is deadly.
• Lenders provide capital for taking risks.
• Competition for deals may cause credit standards to become loose.
• Avoid making decisions for what others are doing.
• Beware of doing whatever it takes to win.