MODULE 2: CLASSES AND KIND OF CREDIT

MODULE 2: CLASSES AND KIND OF CREDIT

Learning Outcomes:
1. Identify and explain the different classes and kinds of credit
2. Know the rationale for classifying credit

From the standpoint of acceptability as a medium of exchange, credit is divided

into two classes, namely, 1) credit of general acceptability and 2) credit of limited
acceptability

CREDIT OF GENERAL ACCEPTABILITY

Credit forms of general acceptability are those that people are willing to
accept in payment of goods delivered or services rendered. Instruments of this class
are known as “credit money” and should possess at least four qualities: they must be
issued by a promisor trusted by people; trusted by people; they must be in
convenient denominations; are easily recognizable; are difficult to counterfeit.
In the Philippines, Bangko Sentral notes are credit money’ since everyone
trusts the government, as represented by the Bangko Sental they are willingly
 MODULE 2: CLASSES AND KIND OF CREDIT

accepted. Since within the country Bangko Sentral Notes work as a medium of
exchange, they are popularly called money.
The bank note is a bank’s promise to pay the bearer. It is printed in
convenient denominations and in some countries, made legal tender for the payment
of all debts. The acceptability of bank notes is due to the prevailing confidence in the
stability of the issuing bank and the denominations issued. Credit is bank’s stock in
trade, something it must maintain at all costs. Its failure to redeem one of its
promises on demand means immediate bankruptcy and ruin. Banks, therefore, guard
their credit with zeal, as a result of which people regard a bank’s promise to pay as
good as money itself.
Any from of credit people generally are willing to accept in place of standard
money becomes credit money whether so called or not. Credit money also serves as
store of value. It is not, however, a denominator or measure of value. Its value or
purchasing power is derived from the value of the things exchanged for it.

CREDIT OF LIMITED ACCEPTABILITY

Credit instruments of limited acceptability are issued under conditions that
make them acceptable only within a restricted field. They include the promissory
note, bill of exchange, various forms of bank credit, and the open book account.
A promissory note is an unconditional promise in writing to pay a definite sum
of money in the future. It is the simplest form of credit instrument and probably the
first form ever used. Such a note may be given by an individual or a business
corporation to obtain funds or in payment of goods. Promissory notes figure in all
loan transactions and constitute a large part of the property or assets of a bank.
For the protection of promissory note holders, law exist to provide for all
possible contingencies. A note, for instance, is negotiable instrument made payable
to order or bearer. Such instruments are not generally acceptable except by those
who have confidence in the maker or endorser. A promissory note, therefore, is
capable of serving as a medium of exchange only with a narrow field. Its main use is
to transfer capital from lender to borrower.
Bank credits are highly important in that they furnish the business world with
medium of exchange often described as “deposit currency”. A bank is an institution
that deals in credit, not money. Since credit is a promise to pay money, a bank must
always have on hand considerable cash in order to keep stock of its accounts and
extend bank credits that are acceptable as money itself.
An illustration of bank credit: A person of good standing wishes to borrow Php
100,000. Since he commands trust, he writes a promissory note for P100,000 and
discounts this at a bank. In that, he sells it to the bank for the sum promised on its
face less interest charged. If the note is payable two months, after date and the rate
of interest is six percent, interest charges will amount to one percent or Php1,000.
He may take payment from the bank in two ways: he may take P99,000 in cash, or
leave the money with the bank as a deposit and received a pass or checkbook,
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drawing upon the bank whenever he finds convenient. The latter is known as
discounting the note. When a bank discounts a note, it increases its indebtedness to
depositors. The word “deposit” as shown by this illustration, is a bank’s promise to
pay money to an individual or corporation.

ACCORDING TO FORM
Credit may be classified according to the kind of accommodation a lender
gives the borrower.

Direct Loan
The lender may give the borrower the exact amount as contained in the
promissory note. The interest is collected at maturity or periodically. For example, a
borrower receives a Php1,000a against his promissory note of the same amount
payable in one year at twelve percent per annum. At the end of the year, the
borrower pays the full amount of P1,000 plus equivalent interest.
Discount
The lender collects the interest in advance and gives the balance to the
borrower. At the end of year, the borrower pays the full amount, i.e., the amount he
received plus interest. In the above example, for instance, if the promissory note is
discounted, the borrower, will receive from the lender only Php880 since the latter
has collected in advance the interest of twelve percent of Php120. At maturity, the
borrower will pay Php1,000.
Overdraft
This accommodation is specifically offered by commercial banks that honor
checks issued even if the amount with drawn is in excess of the net balance in bank.
In this kind of accommodation, there is a pre-arranged amount that can be withdrawn
for a fixed period of time agreed upon between the bank and the customer/depositor.
The overdraft can be covered through subsequent deposits. Interest is computed on
the basis of over-drawings and debited against the account periodically.

ACCORDING TO TYPE OF USER

The classification of credit, in this sense, is the type of borrower, whether an
individual consumer or a business entity.

Consumer or Personal Credit

This kind of credit is usually extended to individuals to fund personal needs
like purchasing merchandise or commodities on a deferred payment plan. This type
of credit may also be used to pay tuition and other school fees, medical or hospital
 MODULE 2: CLASSES AND KIND OF CREDIT

expenses, the construction of a house, or the purchase of lots. The loan is generally
for a short period, except when the amount involved is quite substantial as in building
a home or buying a piece of land, in which case the loan is on a long-term basis. The
borrower repays the loan with his income. Hence, it is not self-liquidating.

Retail Credit
Consumer credit may either be a change or installment credit, both commonly
known as retail credit. When a customer of good credit standing in the community,
who is a regular customer in a department store, is extended a charge account, he
simply signs the invoice without paying cash. At the end of the month, a bill
representing his total purchases for the month is presented to him for payment. To
continue to enjoy the privileges of charge account, a customer has to pay
immediately upon presentation of the bill.
Installment Credit
On the other hand, enables one to buy commodities like a component system
television, computer set, furniture and the like, by paying for such purchases with a
small down payment followed by equal monthly installments until full purchase price
including interest is completely paid.

Mercantile or Commercial Credit

This type of credit, usually extended to commercial and trade investors, is
used to finance the purchase of inventories. It is generally a short-term credit and is
self-liquidating. The terms would depend on the type of goods purchased and length
of time it takes to resell. Sometimes the goods purchased may be in the form of raw
materials, which will be processed into finished products for sale. The terms of credit
may take the length of time from processing and marketing, repayment would come
from proceeds of the sale or resale of the goods.
Goods involved in mercantile credit are those that move through the
production process into the hands of the final consumer or into the possession of a
producer who uses them for further production. As a rule, goods obtained on short-
term credit are not used for further production, except in the case of such inputs that
disappear through one or two operations; rather they are obtained for purposes of
resale. The time involved in the productive process, the sale of the products, and the
collection of proceeds does not usually exceed a year.

Bank Credit
Commercial banks extend short-term credit to businessmen for working
capital purposes, that is, for the purchase of raw materials, the payment of wages,
and other expenses incidental to current operations. The funds involved are the
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active, liquid, and current funds found chiefly in demand deposits accumulated by
commercial banks.
Investment Credit
Businessmen usually obtain long-term funds through intermediary financial
institutions such as investment banks, savings banks, and insurance companies, or
temporarily from commercial banks, primarily to obtain fixed capital, like land,
buildings, machinery, and equipment, or to meet permanent working capital
requirements. It is usually self-liquidating and the repayment of the loan comes from
income derived from the use of the capital goods or capital

Two important characteristics of investment credit differentiate it from

commercial credit. Firstly, the funds involved or transferred are, as a rule, the
inactive funds in the community -chiefly savings. Secondly, goods are seldom
transferred based on investment credit, for mercantile houses and commercial banks
could not afford to tie up their working capital in such operations.
ACCORDING TO MATURITY
Credit it also classified on the basis of the length of time a loan is paid. Thus,
credit may either be demanding loans or time loans.
A demand loan is an accommodation with no definite maturity dates such as:
 Short-term credit. A type of loan payable in one year from the date the loan
was given.

 Intermediate or medium-term credit. Loans of this type range from one year
but not exceeding five years.

 Long-term credit. A type of loan payable from five to ten years and beyond.

ACCORDING TO SECURITY
By and large, credit is extended when it is secured, that is, guaranteed by
some property or collateral. There are some loans, however, that are unsecured and
based solely on the credit standing of the borrower.

Unsecured Loans
These are character or clean loans, backed up solely by the integrity, ability
and willingness of the borrower to pay. A promissory note signed by the borrower
attests to the obligation that may be a single-name paper, where there is only one
person named in the note who will be responsible for the payment of the loan; and
double-name or multiple-name paper, where there are two or more persons named
 MODULE 2: CLASSES AND KIND OF CREDIT

in the promissory note who are jointly and severally liable for the repayment of the
obligation.

Secured Loans
These are loans guaranteed by the assignment of some tangible assets,
which may be sold by the lender in case the borrower fails to pay, the proceeds of
which may be applied to the debt settlement.
ACCORDING TO PURPOSE OR USE
Under this class, credit may be classified as agricultural, commercial,
industrial, and consumer credit.
Agricultural Credit
These are loans granted to finance agricultural land cultivation, development,
and improvement. Some types of agrarian credit are as follows:
Time Loan
This is a short-term loan secured by ordinary and regular collateral, usually,
farmlands, used to finance the development and improvement of the land.
Crop Loan
This is a form of agricultural credit utilized for the production of crops. Aside
from being secured by ordinary collateral, it is further secured by a chattel mortgage
on the standing crops being financed as well as other crops grown by the borrower.
Commodity Loan
This loan is used to finance the marketing and distribution of harvested crops.
It is also granted to farmers who have stored their crops in warehouses. This credit is
secured by quedans or warehouse receipts.
Commercial Credit
This type of short-term loan finances the production and distribution of
commodities by wholesale or retail, in storage, or in transit to foreign or domestic
markets.
Industrial Credit
Industrial credit is used to finance the manufacture of goods, construction of
plant buildings, or acquisition and installation of equipment or machinery. It may also
be used to finance the operation of a factory or the purchase of raw materials.
Consumer Credit
This is a type of loan granted to individuals for personal use and immediate
consumption such as the purchase of goods or services, small investment purposes,
tax payments, and other obligations.
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RATIONALE FOR CLASSIFYING CREDIT

The discussion described loans, transacted in the Philippines context. In a
broader perspective, classification may be modified by new schools of learning,
financial settings, cultural differences, and the global climate. This notwithstanding,
the significance of credit classification is imperative to an economy that leans heavily
on selective credit controls as a tool to achieve monetary stability.
Loan classification is likewise important to a shopper of credit, for time and
effort can be saved by identifying the need before exercising options. For instance,
commercial loans are granted by various kinds of banking institutions. Therefore,
one who needs such a loan can immediately direct his application to the specific
bank. Moreover, credit classification is a vital aid in policy-making or policy reform.

COMPANY CREDIT POLICIES

CREDIT POLICIES
 Policies are general statements used as guides for the members of an
organization as they perform their jobs.
 Policies provide guidelines on routine and repetitious.
 Policies designed or set at various levels:
 Strategic policies at the top management level
 Tactical policies at the middle management level and
 Operational policies for the ran-and-file.
 Policies reflect the objectives and management philosophy of the
organization.
 The credit department proposes credit policies, later approved by the Board of
Directors who may delegate this function to a credit committee or the
company president.
 The Bangko Sentral heavily regulates banks. Most of their credit policies have
to conform to Bangko Sentral regulations.

A company credit policy outlines the terms and conditions under which the company
extends credit to customers. It's essential for managing cash flow, minimizing bad
debts, and protecting the company from financial risk. Below is a general outline of
what a company credit policy might include:
1. Credit Terms
 Payment Terms: Define the period within which customers must pay (e.g.,
Net 30, Net 60 days).
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 Discounts for Early Payment: If applicable, specify discounts offered for

early payments (e.g., 2% discount if paid within 10 days).
 Late Payment Penalties: Outline any fees or interest charges for late
payments.
2. Credit Eligibility Criteria
 Credit Application: Require customers to fill out a credit application providing
financial information, references, and agreement to terms.
 Creditworthiness Evaluation: Criteria such as credit score, financial
statements, trade references, and payment history to determine if the
customer qualifies for credit.
3. Credit Limit
 Maximum Credit: Specify the amount of credit extended to each customer
based on their creditworthiness.
 Review Process: Regular review of the customer’s account for credit limit
adjustments or revocation if necessary.
4. Payment Methods
 Accepted payment methods (e.g., checks, bank transfers, credit cards).
 Policies on returned checks and handling fees.
5. Collection Process
 Reminder Notices: Timelines for sending reminder notices after a payment
due date.
 Collection Procedures: Outline steps for pursuing unpaid invoices, including
internal collections, third-party collections, or legal action.
 Dispute Resolution: How the company will handle billing disputes, including
deadlines for raising disputes and procedures for resolution.
6. Customer Communication
 Regular communication with customers about account status, overdue
balances, and upcoming payments.
 Clear escalation procedures for addressing delinquencies.
7. Credit Policy Compliance
 Ensure all employees, especially those in sales and finance, are trained in the
credit policy.
 Have a process for monitoring adherence to the credit policy internally.
8. Policy Changes
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 Procedure for reviewing and updating the policy regularly to reflect changes in
market conditions or company strategy.
 Notice periods for customers when significant changes are made to credit
terms or limits.

A well-defined credit policy helps the company maintain a balance between

extending credit to promote sales and protecting itself from credit risk.

The basis of credit is trust. Lenders extend credit to borrowers based on the belief
that the borrower will repay the debt by the agreed-upon terms. This trust is often
evaluated using a framework known as the

Five Cs of Credit:

Character: This refers to the borrower's trustworthiness and reputation. A strong

credit history, including a record of timely payments, is a positive indicator.
Capacity: This assesses the borrower's ability to repay the debt, considering factors
such as income, expenses, and debt-to-income ratio.
Capital: This refers to the borrower's financial resources, including savings,
investments, and assets.
Collateral: This is something of value that the borrower pledges as security for the
loan. If the borrower defaults on the loan, the lender can seize the collateral to
recover their losses.
Conditions: This refers to the economic conditions that may impact the borrower's
ability to repay the debt, such as interest rates, inflation, and job security.
By evaluating these five factors, lenders can assess the risk of lending to a borrower
and determine the appropriate terms for the loan.