GENERAL FUNCTIONS OF CREDIT

BY: Prof. Caroline Grace E. Mella

General Functions of Credit

• Credit benefits the entire economy.

• It makes possible the formation of large enterprises
that result in economies of scale, which in turn will
reduce the cost of production and lower prices (from
wholesale to retail levels).
• Lower prices make it possible for a much larger portion
of the population to enjoy the benefits of affordable
products, thus improving the quality of life of almost
everyone.
General Functions of Credit

• The first economic benefit refers to the

MANUFACTURING SIDE.
• The larger the enterprise, the more
economy of scale is achieved.
• This concept of economy of scale could be
best illustrated by using as example
FIXED COSTS and VARIABLE COSTS.
General Functions of Credit

• FIXED COSTS are business expenses that do not

vary in relation to production.
• An example of a fixed cost also called
OVERHEAD EXPENSE is RENT.
• Even if the production in terms of quantity or
number of units produced, whether 1 unit is
produced or 10,000 units, the rent remains the
same, or fixed.
General Functions of Credit

• A VARIABLE COST directly varies with

production.
• Examples of variable cost are raw
materials and direct labor that directly
attributable to a finished product.
General Functions of Credit

• If a company’s fixed costs per month is

P100,000 and its variable costs is P10 per
unit of production, the cost of production per
unit will be decreasing as the production
output increases.
• Production systems with large capacities
tend to have lower costs of production.
General Functions of Credit

• The second benefit of credit to the economy

is the EXPANSION OF THE PURCHASING
POWER OF THE CONSUMERS.
• When the purchasing power of the
consumers is expanded, this increases
demand and the actual consumption, which
in turn will require HIGHER PRODUCTION.
General Functions of Credit

• A somewhat similar situation applies in

economics: an expansion in
purchasing power through credit
availability, is “demand-side”
economics.
• It energizes economic activity towards
the whole distribution system.
General Functions of Credit

• An expansion in investments in the

manufacturing sector, brough about by
the use of credit, makes new
innovative and cheaper products
available, also energizing economic
activities.
• This is SUPPLY-SIDE economics.
General Functions of Credit

• The 3rd benefit of credit is the

SAVINGS IN TIME AND
TRANSACTIONAL EXPENSES, which
makes the process in the entire
distribution system, from manufacturer
to consumers, more convenient and
efficient.
General Functions of Credit

• The 4th general benefit of credit is the

MULTIPLIER EFFECT, another
concept borrowed from economics.
• Large-scale credit that results in the
creation of large enterprises will
necessarily empower new, or enhance
old, linkages.
General Functions of Credit

• A business enterprise is linked to other

enterprises: factories need suppliers of
raw materials; large volumes of good
require large transport equipment.
• Executives and employees of these
enterprises have to travel and provide
entertainment to clients.
General Functions of Credit

• Advertising contracts must be

obtained.
• The linkages here are production
(factory), transport enterprises, travel
companies and hotels and restaurants,
advertising companies, among many
more others.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

1. The introduction of large amounts of credit

could re-charge a stagnant economy
- Credit granted by a bank to manufacturer could
precipitate another credit transaction, this time
between the manufacturer and its customers, the
wholesalers; and so forth.
- This is similar to the “multiplier effect” in
economics.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

The volume of transactions from a chain,

would result to:

a. More employment opportunities for sales

clerks to handle the extra sales volume,
bookkeepers to record them, and even
employment in the government sector to track
down sales for tax purpose.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

The volume of transactions from a chain, would

result to:

b. Suppliers of raw materials would also experience

a sharp growth in orders, again possibly opening up
new employment.
c. Newly-generated profits could translate to higher
taxes for public works development, bigger
investment on plant, equipment and research.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

2. Credit helps manufacturers, wholesalers,

retailers and end-users
Manufacturer. If a manufacturer can obtain credit, it
may replace its obsolete equipment and reduce
production cost per unit, resulting in lower selling
prices.
The lower prices will certainly give it an advantage
vis-à-vis its competitors, resulting in higher sales
and higher profit margins. Also with lower prices,
consumers will be directly benefited.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

2. Credit helps manufacturers, wholesalers,

retailers and end-users

Wholesalers and Retailers. With available credit,

they may purchase in bulk to get volume discounts,
or pay on time or quality for prompt payments
discounts.
By lowering cost, they can increase sales by
reducing their prices.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

2. Credit helps manufacturers, wholesalers,

retailers and end-users

Or with credit, they may allocated funds to improve

their distribution systems, or improve their display
counters to increase sales per square meter of store
space, or increase their advertising budgets – all of
which will contribute significantly to bigger sales and
profits.
 Advantages and
Advantages of Credit:
Disadvantages of Credit

2. Credit helps manufacturers, wholesalers,

retailers and end-users

End-users or customers. Are able to enjoy a

better quality of life without having to accumulate
funds; they may immediately purchase the items
that would improve their living conditions, their
health, or education.
 Advantages and
Disadvantages of Credit:
Disadvantages of Credit

1. The availability of credit affects or distorts

the way of thinking of some managers – they
tend to relax and forget that credit is not free
and have to be paid when the due date
comes, plus interest and charges.
2. Very aggressive users of credit tend to
ignore risk, some going into highly
speculative and unplanned ventures.
3. Credit increases the cost of doing business.
 Advantages and
Disadvantages of Credit

The availability of credit has its disadvantages,

however, the advantages far outweigh the
disadvantages, especially from the prudent
businessman’s point of view.

A financial advantage as a result of credit is

illustrated in the following slides:
 Credit

Company A Company B
Investment P1.0 Million P1.0 Million
Total Sales per Year P10.0 Million P10.0 Million
Gross Profit/ year P500,000 P500,000
5% of Sales
 Store B decides to get a
P500,000 Bank Loan

Company A Company B
Investment P1.0 Million P1.0 Million
Borrowed Funds - P500,000
Total Investment P1.0 Million P1.5 Million
Total Sales per Year P10.0 Million P15.0 Million
Gross Profit/ year P500,000 P750,000
5% of Sales
Less Overhead (P300,000) (P300,000)
Loan Interest (20%) (P100,000)
Net Profit P200,000 P350,000
 THE COST OF CREDIT

1. INTEREST
2. CREDIT AND COLLECTION OVERHEAD
EXPENSES
3. BAD DEBTS
 THE COST OF CREDIT

1. INTEREST - Interest is calculated as a

percentage of a loan (or deposit) balance,
paid to the lender periodically for the
privilege of using their money. The amount
is usually quoted as an annual rate, but
interest can be calculated for periods that
are longer or shorter than one year.
 THE COST OF CREDIT

2. CREDIT AND COLLECTION OVERHEAD EXPENSES

1. COST OF CREDIT INVESTIGATION/ PROPERTY APPRAISAL/ BACKGROUND
CHECK
a. Salary of Credit Investigators
b. Travel Expenses
c. Retrieval Fee (cost of getting information) from the Credit Bureau or
computerized data banks, if it exists, including membership fees
2. COST OF RECORDING AND MONITORING ACCOUNTS RECEIVABLE – SALARIES,
PAPERWORK
3. COST OF COLLECTION – SALARIES, TELEPHONE, POSTAGE, TRAVEL AND LEGAL
FEES.
 THE COST OF CREDIT

3. BAD DEBTS
- No company in the course of doing business
over a considerable period of time, is
impervious or immune to bad debts.
- Bad debts is the most expensive of the 3
costs of credit
 THE COST OF CREDIT

SALE PRICE OF GOODS P25,000

SOLD ON CREDIT
COST OF GOOD SOLD P20,000

EXPECTED GROSS PROFIT

ON THE SALE P5,000
 THE COST OF CREDIT

• Not only will the company lose the opporturnity on the

P5,000 potential profit; it will also lose the entire
P20,000 cost of goods sold.
• Bad debts of course are not entirely lost. The creditor
may attempt to recover through judicial or extra-judicial
means.
• Even if the judgment is favorable to the creditor, the
amount recovered when carefully calculated, will not
compensate for the loss of the time value of money
and the opportunity for profit.
 THE COST OF CREDIT

• What is lost forever is the account of a customer.

• If such a customer had been a valued customer
for say, 5 years buying P50,000 a month, and the
lawsuit is due to a simple misunderstanding –
like the delivery date, a request for a short
payment extension which was denied, or strong
and insulting language from one of your
collectors – the loss is irreparable but regrettable.
HIDDEN COST OF CREDIT

• This is particularly in transactions

between retailers and end-users or
consumers.
1. Vehicle Insurance
2. Registration Fees
HIDDEN COST OF CREDIT

1. Vehicle Insurance
- Many lenders for chattels, in cars and
motorcycles require comprehensive insurance
coverage for protection of both the sellers and
buyers.
- These buyers, including those applying for loans
using their used vehicles as collateral, are forced
to purchase insurance from an insurance
company dictated by the lender or seller.
HIDDEN COST OF CREDIT

2. Registration fees (Processing Fees)

- The buyer is required to pay for registration of chattel
mortgage/ loan contract, or real estate mortgage in the
case of cash loans.

- What happens, however, is that the amount that the

buyer has to pay is inflated or increased; the excess is
justified by the branch manager as ‘grease money’ for
the quick documentation of the said mortgages. This is
an added burden to the borrower.
OPPORTUNITY COST OF CREDIT

If a company does not extend credit

when by doing so, an additional net
profit (after interest expenses) of, say
P1.0 Million is lost, that P1.0 Million
represents the opportunity cost of
not using credit.
OTHER CREDIT CHARGES

SERVICE FEES/ SERVICE CHARGES

- Many lenders have other charges that are not
considered as interest, the most common are
service fees.
- This type of fee or charge is applicable to loans.
- It is a percentage of the loan amount and is
always deducted from the proceeds of the loan.
OTHER CREDIT CHARGES

SERVICE FEES/ SERVICE CHARGES

- This fee increases the yield of the lender
and the cost of credit to the borrower.
- An example P100,00 loan, 12% interest
per year, with principal and interest
payable at the end of one year. The
effective interest on this type of loan is
12%.
OTHER CREDIT CHARGES

SERVICE FEES/ SERVICE CHARGES

Interest = P12,000 12% effective interest

Net Proceeds P100,000

If the bank will get a 10% service fee, the

amount of P10,000 will be deducted from the
proceeds of the loan and the net proceeds will
be reduced to P90,000.
OTHER CREDIT CHARGES

The effective interest rate will also

change:

Interest + Service Fee = P22,000

= 24.44% effective Interest

Net Proceeds P90,000

OTHER CREDIT CHARGES

Lenders do this not only to increase their yield on their

loans, but also to go around regulations that require certain
types of credit not to go beyond prescribed maximum
interest rates.

For example, if a certain type of credit is mandated by

regulation to have a maximum interest rate of 18%, what a
lender can do is charge 10% service fee so as not to violate
the regulation on maximum interest rates, and the same
time, increase its yield on the loan.
OTHER CREDIT CHARGES

The yield on the loan WILL DRAMATICALLY INCREASE, as

the example showed, FROM A YIELD OF 12% to 24.44%.

Service fees are often times charged on top of non-

refundable application fees.

Other charges are sometimes also deducted from the loan

proceeds: NOTARIAL FEES, DOCUMENTATION FEES
AND OTHER IMAGINABLE BUT JUSTIFIABLE
CHARGES.