CRIDIT MANAGMENT
MBA 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.
Supply
Funds
Lenders Arranged by the Banks borrowers
Repayments
Obligations
Indirect Financing /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
Supply
Funds Supply
Funds
Lenders Arranged by the Banks borrowers
Repayments Repayments
Obligations 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
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
1. Public Credit ( Govt. bodies incur debts)
2. 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:
1. 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 scoring
Five C’s
1. Character: the customer’s willingness to meet credit
obligation.
2. Capacity: the customer’s ability to meet credit
obligation out of operational cash flows.
3. Capital: the Customer’s financial reserves.
4. Collateral: A pledged assets in case of default.
5. 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;
1. Financial statements
2. Credit report on customer’s payment history with other
firms (rating agencies, like poor and standard, Dun and
bradstreet, etc.)
3. Banks
4. The customer’s payment history with the firm.
Analyzing credit Policy
Credit 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.
