CRIDIT MANAGMENTMBA Banking & Finance

3rd Term

Financing Methodology

• What is The Financing System?

“In formal terms, the financing system allocates funds from surplus units to deficit units.”

• Surplus units: A surplus unit is any party whose income over a period exceeds its outlays.

• Deficit units: A deficit unit is any party whose income over a period is less then its outlays.

• For Pakistan economy as a whole the foreign sector has been the main source of surplus units, followed by the household sector, whereas the corporate and government is generally been in deficit

• The financing system comprises suppliers and users of funds.

• The suppliers are investors who seek a return from supplying funds. However the future returns involves some degree of risk. Hence supplier of funds considers both risk and return making decision.

Types of Financing

There are two types of financing

• Direct Financing

• Indirect Financing, intermediated Financing.

Direct Financing

Direct Financing: Raising funds from financial markets involve the issue of securities. Direct financing mainly occur in capital markets.

Lenders Arranged by the Banks borrowers

Supply Funds

Repayments Obligations

Indirect financing or intermediation

The alternative process to direct financing is intermediation. This occur when financial institution acts as the borrower to surplus units and the lender to deficit units. The process creates two set of assets and liabilities. Intermediary’s deposits are both its liabilities and the assets of the lenders

Lenders Arranged by the Banks borrowers

Supply Funds

Repayments Obligations

Supply Funds

Repayments Obligations

Principles of Non –interest commercial financing Funds can be either lent on the basis of a promise to

repay with interest with future date is called interest bearing financing or debt financing. Debt funds are raised for given terms. Main instruments of debt capital are loans and advances by financial institutions. Domestic and foreign debts market can be used for raising fund.

Equity financing

Equity financing:

where contribution to fund is made on the basis of a promise to share in the distribution of profits. equity funds are provided for life of business. Equity instruments are used for raising equity fund. Domestic and foreign equity markets can be used. The main instruments are share or stock.

What is credit?

Derived from Latin word credere, mean “to trust”

There are three forms of money:

Metallic money

Paper money

Credit Money: When there are obligations to make payment at some future date, the person to whom the future payment is to be made, the obligation is called credit. It is a debt for a person who is obliged to make payment on demand or some future time.

Credit may be defined….

The right to receive payment or the obligation to make payment on demand or at some future time on account of an immediate transfer of goods.

The credit is based on the confidence and belief that debtor whether it is a person, business firms or government unit will be able or willing to pay in future.

Two phrases are used in definition

“Right to receive payment and the obligation to make payment”

The first phrase is used from creditor point of view &

The second phrase is used from debtor point of view.

Credit Culture

The history of credit clearly shows that credit is not a new invention but used in different civilizations in past with in different shapes.

• 3000 years ago in the civilization of Babylon

• Europe is the first period rich in material for the historian of credit. (12th century)

• Most of the commerce of Western Europe in those times was hinged in great trade fairs.

• The merchants from Italy began to leave agents on permanent duty at the fairs. They were using “ cambium contracts” the document which permitted the transfer of funds from one place to another ( changing currency on route) developed business entirely on credit basis.

Credit Culture (continued)

• Typical of these trader was Symon di Gualterio a marchant who in march 1253 in champagne purchase english cloth from a Parman trader agreeing to pay in july.

• More example of credit trading are found in England where in from thirteen century or earlier dealings in wine, cloth wool and leather on credit basis.

• Another example of credit techniques evolving to meet a need is the development of the bill of exchange in the Italian city –states of the fourteenth century, the simpler instrument then the cambium contract.

• The contrast to modern bill is that these bill were never discounted or transferred by endorsement.

Credit Culture (continued)

• Mostly in past the trade credit transactions were occurred. The history of consumer credit is of comparatively of recent origin.

• The basic objective of credit was to promote sales. This is even more applicable today.

• Credit is also used and uses today for to counter trade recession.

• Handling of marginal customers.

• Assisting established customers.

Types of Credits

Credit is classified on different basis:

Classification of credit on the basis of uses.

Classification of credit on the basis of its maturity.

Classification of credit on the basis of the nature of the debtors.

Classification of credit on the basis of Uses…1. Investment Credit as the name suggests is used for

fixed capital and for capital goods. The chief institutions extend investment credits are commercial banks, investment banks, insurance companies, investment trusts; development corporation, etc.

2. Commercial credit extend for short period and is required for financing the current business operations such as production, manufacturing, etc. shorter term loan used as a working capital

3. Consumption credit which is extended for non business purposes. A consumer is sometimes not able to meet his demands out of current income. He is to buy a car, television etc.

4. Speculative credits: Credit is also used for speculative purposes. The speculator may borrow funds from the commercial banks or from the brokers for the nominal purchases of commodities or securities to make profit on A/c of change in prices.

Classification of credit on the basis of its Maturity

1. Long term credit (3 to 5 years)

2. Intermediate term credit ( 1 to 3 years)

3. Short term credit ( Less then 1 years)

4. Demand credit. ( Payable on demand)

Classification of credit on the basis of the nature of the Debtors

• Public Credit ( Govt. bodies incur debts)

• Private Credit ( Non governmental bodies acquire goods in the present and to pay in future).

Credit Policy Constituents

Credit policy refers to the carefully documented instruction issued to each part of the operation to ensure the correct procedures are being followed by their respective staff, so that each knows its own precise involvement and responsibility.

Following points must be consider in credit policy:

4. The choice of credit Facility

Full consideration should be given to the various credit facilities available, with the joint aim of satisfying needs of customers and to achieve maximum benefit for the business.

2. The credit application

The manner in which the customer’s application or credit is dealt with will depend on the type of business being conducted.

3. Credit decision

There must be credit office or credit department to assess the applicant using different tools and techniques making decision.

There are no marginal formulas for assessing the probability that a customer will not pay. The collection of credit information and its assessment is generally used as a tool to make credit decision.

Credit evaluating and scoringFive C’s

• Character: the customer’s willingness to meet credit obligation.

• Capacity: the customer’s ability to meet credit obligation out of operational cash flows.

• Capital: the Customer’s financial reserves.

• Collateral: A pledged assets in case of default.

• Conditions: general economic conditions in the in the customer’s line of business.

Credit Scoring: The process of quantifying the probability of default when granting consumer credit.

Credit Information

The information commonly used to assess the credit worthiness included the followings;

2. Financial statements

3. Credit report on customer’s payment history with other firms (rating agencies, like poor and standard, Dun and bradstreet, etc.)

4. Banks

5. The customer’s payment history with the firm.

Analyzing credit PolicyCredit policy effects

In evaluating credit policy there will be five basic factors to consider.

Revenue effect: If firm grants credit, then there will be delay in revenue collections as some customers take advantage of the credit offered and pay later. How ever the firm may be able to charge the higher price if grants credit and it may be able to increase the quantity sold. Total revenue thus may increase.