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Credit is the means by which we are able to obtain immediate benefit of goods or services upon the promise of payment at a future date.
Whether we are a recipient of credit or not, credit affects our everyday life and indeed our jobs depend upon credit in one form or another.
As individuals we receive credit either by the use of mortgages and hire purchase facilities, credit cards, cheque books or simply by being allowed to pay our accounts monthly (gas, electricity). As we receive credit, so we are expected to give credit and we do this by allowing our employers a week or a month's credit in which to pay for our services. This, of course, is not the same as commercial credit, but nevertheless the principle still holds true.
One of the main reasons for obtaining credit is that money which is our recognised unit of exchange is kept in relatively short supply, and although we may have enough for small purchases, it is usual to borrow or obtain credit for those items which we require but cannot immediately afford, and as this problem is not confined to individuals, so we find business firms seeking credit. Indeed, without such facilities many firms would not be in existence today. Such money sought by business is used to invest in its future prosperity by purchasing assets, such as plant, machinery, etc. In addition to its capital it also requires short-term finance and this usually obtained from suppliers. How much is borrowed is dependent upon the nature of the business. However, whatever this may be any form of borrowed money must be repaid. The ultimate purpose of a commercial enterprise must therefore, be to make profits, and as the business world revolves around credit, achieving this objective not only maintains the equilibrium by enabling an enterprise to meet its commitments, it also encourages expansion, providing of course nothing untoward happens to upset the market.
It is generally accepted that in normal circumstances expansion means more work, which in turn creates greater prosperity. There are factors which of course can and do influence this logic, but it is not intended to discourse on these here. Enough to say that Buoyant Trade encourages spending.
Capital borrowed by a business enterprise is usually obtained from banks. As money is the most important asset a bank has, its natural tendency must be to increase this asset, which it does by making loans available, subject of course to the bank's own conditions and any conditions that might be decreed by government.
Uncontrolled credit not only creates difficulties in a business enterprise, it is also a cause of inflation. We know that credit enables expansion and given the correct circumstances, expansion feeds on itself and in doing so creates greater spending power, and unless spending is curbed or channelled in the right direction, we create an imbalance between supply and demand and so cause a price spiral or inflation.
To prevent this happening, the supply and regulation of credit is controlled by the Government by forcing the commercial banks to deposit a percentage of their liquid assets with the Bank of England. When deflation is required, the deposit to be lodged is increased, conversely expansion is achieved by reducing the level of deposits, thereby enabling banks to invest more of their money by way of increased loans.
It is of course possible to obtain credit from sources other than the bank, but the interest on such money would discourage all but the most desperate of borrowers.
Some of the most difficult markets a manufacturer can enter are to be found in the export trade, where, as in the home trade, purchasers ask for credit and as some competitors are very generous with their terms we, to whom exports are of vital importance, must match these terms. So we find credit playing an important part in international trade.
Definition of Credit
The word "credit" has a variety of meanings which can be found in daily conversation.
The dictionary defines credit in many ways, but we are interested in only the following definitions.
These definitions form the basis for commercial credit. We establish a customer's reputation, and we create confidence by establishing our customer's ability and intention to pay.
It should therefore, be obvious, that for the word "credit" to have any meaning, these principles must be adhered to and we must avoid confusing credit with what is generally termed as "doing favours", or simply not bothering to assess credit worth because we think the customer is "O.K.". These attitudes must be avoided as all that has happened is that a gamble has been undertaken with the inevitable crop of doubtful and bad debts.
Credit assessment of the potential customer follows a fairly regular pattern, the application of which leads to a credit limit, when justified. Once a credit limit has been fixed any subsequent increase is not to be undertaken before the account has been re-assessed, this is of particular importance, as we could be encouraging the customer to live beyond his means and by doing so the result could be either bankruptcy or liquidation.
Overdue accounts must be collected and should the customer be unable to meet his commitments, the inevitable stoppage of supplies ensues with the resultant loss of goodwill.
Naturally we are in business to make money and it is our duty to sell the customer as much of our product/services as possible, but this must be commensurate with the credit worth. Customers are of no value unless they pay for what they buy.
Should there be any doubt as to the wisdom of this attitude, one need only refer to the financial institutions and in particular to the banks. A bank's objective is to make money and one of the methods used to achieve this is by loans. However, loans are only granted to those whom they have every confidence in and then, as often as not, demand some form of security. The motive for loaning money is therefore to acquire profit for themselves and not out of any favour to the customer. Although we are not able to adopt such stringent attitudes, our motive for granting credit must be the same.
The better we are able to understand the implications and uses of credit, the better equipped we will be to handle the many associated problems.