Chapter 1

CREDIT FUNDAMENTALS

Credit - Its Meaning and Importance

Credit is an arrangement to receive cash, goods or services now and pay for them laten This is the
easiest and simplest definition (Personal Finance - Kapoor, Dlabay, and Hughes, 2nd ed.)

Credit is defined in many ways. In business, credit is viewed differently. To a lender it connotes trust on
the borrower's capacity and willingness to pay. To the borrower, it is the ability to obtain goods or
services in exchange for a promise to pay.

In this book, credit is defined as a transaction involving the transfer of goods, services, funds, property
or rights, thereby creating an obligation on the part of those who receive them, that must be complied
with in the future.

This definition indicates an exchange between 2 parties: the first party providing the goods, services,
funds, property, or a right and the second party, who receives any of them, will have the obligation to
comply with this obligation by promising to pay for them in cash, in kind or to return the thing
borrowed. These parties, respectively, are generally called the creditor and the debtor. Other
synonymous terms are lender in lieu of creditor, and borrower for debtor.

Ordinary English usage would prefer one term to the other, depending on the circumstances. For
example, a person providing a cash loan could be called either a lender or creditor, but a person who
lends a hammer for temporary use by a neighbor could not appropriately be called a creditor, but is
properly referred to as the lender of a personal property. A person allowed to use a friend's jeep could
simply not be referred to as a debtor (a debtor connotes a debt, usually involving a cash loan) but as a
borrower.
The 5 items that are provided by the lender or creditor per this definition (3rd paragraph, page 1) are,
more or less, very commonly encountered by ordinary individuals:

Schedule

ITEMS

EXAMPLES

1. Goods Groceries, appliances, medicines, hardware

2. Services Car repair, beauty parlor services, electrical current

3. Funds

Cash loan from a pawnshop, bank, or a friend.

4.

Property A hammer for temporary use by a neigbor, a car for use in an errand (personal properties); a
beachhouse for use for a weekend (real property)

5. Rights

Possession or use of a commercial store space bonds, stocks, commercial paper, loan on receivables.
For the above 5 items, whenever a credit transaction is created, by virture of an agreement, the terms
used for the providers (of the goods services, funds, etc.) and the users would certainly vary. For items
No. 1 and 2, a creditor-debtor relationship is created - the provided of goods and services is called the
creditor, and the recipient or user thereof, the debtor. In item No. 3- funds the terms used are lender
and borrower. In item No. 5, the lessor (he who owns the commercial store for rent) an the lessee (he
who rents it). In item No. 4, where transactions are covered by commadatum contracts, the owner of
the personal or real property being lent (by the owner or possessor) is called the bailor, and the
borrower, the bailee.

The typical Filipino student would probably confuse the term bailor and the bailee with a bail bond
required for persons criminally accused in a court of law. They are different. The reason why the terms
bailor and bailee are being used is because the general body of civil code articles on this type of
transactions are classified under the general term: bailment.

Not all of these 5 types of transactions would necessarily result in the creation of credit. Most of the
credit transactions, however, are almost always sale transactions (item No. 1) and cash loans (item No.
3). A transfer of goods without a sale is, of course, possible, and in fact there are many transactions that
do not result in a sale.

What is a sale? First, the distinction between ownership and possession must be made clear. Ownership
confers legal title to a property or a right; while one who possesses has physical control of a property or
a right. For example, the owner of a farm in Ipil, Zambanga Sibugay, could be Mr. X, who resides in Cebu,
and the possessor is Mr. Y, a farmer who resides there and uses it for rice and vegetable farming.

A credit transaction, please note in the definition in the 3rd paragraph page 1, is a transfer of goods, or
services etc. A sale is also a transfer of goods or services. Art 1458 of the Civil Code says: "by the
contract of sale one of the contracting parties obligates. himself to transfer the ownership of goods or
services and to deliver. a determinate thing and the other to pay therefore a price in money or its
equivalent." In a sale, whether on a credit arrangement or not,it is the intention of the parties (the
vendor or seller and the vendee or buyer) that both the ownership and possession of goods or services
be transferred to the buyer, who must pay for them. The transfer of ownership is evident in Art. 1458:
"to transfer the ownership of goods or services"; the transfer of the possession could be inferred from
the same Article in the statement: "to deliver". Delivery refers to transfer of possession.
In a sale, the vendor's (also called the seller) obligation is to deliver a determinate thing, that of the
vendee's (or buyer) is to pay for it either now or in the future. If he pays now, the buyer's obligation is
fully complied with and extinguished, and there is no credit transaction. If he promises to pay in the
future, the obligation will remain outstanding until fully paid. By promising to pay later, a credit
obligation arises.

The definition of credit in page 1 points to 5 types of items (goods, services, etc.) which are the objects
of transactions that would possibly result in credit. This 5-item classification (again enumerated in
Schedule 2) tells us that there are at least 5 different ways in which a credit transaction is created. There
are many other ways. The most common, as previously mentioned, are credit obligations arising out of
sale transactions and cash loans. In rent transactions, credit would sometimes result. Since most rental
contracts require advance payment for the incoming month, credit is never intended to be a result of a
rental contract. When a lessee defaults, or fails to pay, on a rental payment, credit is not actually
created. A credit transaction is consummated by mutual consent and the non-payment of rent on due
date is certainly not intended by the lessor or owner of the rental property. However, by virtue of a
grace period (time allowance to pay a rental beyond the due date) , usually included in most
lease/rental contracts, a credit transaction is automatically created on a temporary basis. When a lessee
requests for an extension beyond the grace period, and it is approved by the lessor (the owner of the
rental property), a credit transaction also results by mutual consent.

In Schedule 2, item No. 4 deal primarily with personal and real properties, or even rights, that are being
lent and borrowed for free. These transactions are covered by commodatum contracts which are
seldom encountered by employees or managers. And in everyday usage, such transactions are almost
always on a verbal basis. Examples: the owner of a neighboring store would like to borrow your delivery
truck, for free, as favor, or a cousin's wife borrows your Isuzu Crosswind to be used as a bridal car,
"gratis et amores". Most commadatum agreements as stated, are verbal, and the terms of the contract
are not spelled out in detail. If your neighbor borrows your hammer, would you actually ask him to sign
a commodatum agreement?

If a property is lent out for a fee, the contract to be used is a contract of rent or lease.

What is the purpose of this 5-item classification? It is useful for both creditors-lenders and debtors-
borrowers to be well informed of the relevant and primary provisions in the Civil Code that govern a
particular type of transaction, thus:
Schedule 2

ITEM NO. PROVISIONS

1.

2.

3.

4.

5.

CLASSIFICATION

Sale

Contract for services

Cash loans

Property (commodatum)

Incorporeal Rights
CIVIL CODE

Arts. 1458-1637

Arts. 1689-1754

Arts. 1953-1961

Arts. 1935-1952

Arts. 1624-1635

It is by referring to these legal provisions that the parties to a transaction would be properly guided. By
necessity, however, it must be stated: first, that there is no substitute for professional legal advice,
second, there are other provisions in other parts of the Civil Code and other bodies of Philippine laws
not enumerated in the previous pages which may have to be applied in certain cases involving credit.

Reasons for concern. When a transaction is consummated and all parties are satisfied, there is no reason
to be concerned. But since a transaction could turn sour, or pose a problem, or even create a legal
dispute, such as when:

1. Goods delivered are spoiled or substandard

2. Services provided such as car repair are inadequate or technically defective; or

3. When the prices, for either goods or services, were not clearly understood by both parties (when
price is not considered certain in money or its equivalent, there is no sale, and the transaction is void
there being no mutual consent.
Systems approach. There are many ways one can respond to problems resulting from day-to-day
transactions. An approach, where a credit and collection manager reacts to problems as they occur,
oftentimes applying "band-aid" solutions, is not suggested.

The prudent credit and collection manager must look at the total credit and collection process or
system. Credit problems resulting from transaction errors, especially those that may lead to court
action, will certainly create difficulties such as:

1. High costs of litigation: lawyer's fees, court filing fees;

company-paid salaries of employees attending court hearings. 2. Permanent loss of customer business -
a court case or even an arrogant or uncalled for demand letter could certainly be a turn-off for a good
customer.

3. Cash flow problems due to non-collection (either payment delays or bad debts)

4. Tension to the employee who caused the problem; employees under stress are not efficient or
productive employees.

5. The time and mental disposition of managers are dissipated and disrupted.

6. In situations where the company obtains credit by factoring its receivables (to be explained in another
chapter), or using the company's receivables as collateral, and if the promissory notes and other
accessorial documents are defective, its credit application would be either delayed or rejected, resulting
in more cash flow problems.

It would be best to avoid problems by handling transactions properly, from the very beginning, with the
use of appropriate documents, free from defects. "An ounce of prevention is better than a pound of
cure.
There are many large mature companies whose credit and collection system has been in place for a
considerable period of time. Their business philosophy, strategies, organizational structures and
procedures have been tested over time. In this kind of a situation, the best advice to a manager is an
American idiom: "if it ain't broke, don't fix it."

Sometimes, however, a newly-hired manager finds himself working for a company with a credit and
collection system in place but requiring a lot of changes, perhaps even a major overhaul. In many cases,
particularly in small enterprises that have grown quickly, no system of any kind is visible; managers and
employees respond to problems as they arise, on a "touch and go" basis.

Like in the other functional areas of an enterprise (marketing, production), the systems approach is
always recommended, provided, of course, that it is feasible primarily in terms of the company's
financial resources and the adaptability and adjustability of its employees to the recommended
approach. A credit and collection system should be capable of being handled with ease by the
employees. A sophisticated, confusing set of procedures, if not completely understood, could cause
more problems, or might even cause inaction and partial paralysis in the organization.

In a systems approach, problems are looked at not on a single- incident basis, but in relation to the total
system.

If a particular problem keeps on repeating, for example, prices are not properly written down, or
payment terms are not clear, it is possible that such defects are due to a newly-hired and still untrained
employee. Perhaps, the problem is superficial and there is no need to review the total system. Or,
perhaps, it is system-related.

A worthwhile example, using a systems approach, is the evaluation of the credit criteria of a company.
The manifested problem is low sales, which is an area of concern for another department (marketing).
Are sales down because of the company's product deficiencies (low quality, no warranty when
competing products carry them), inappropriate promotional efforts, or an un- appealing advertising
message? Or is there a continuing downtrend in sales because of the strict credit requirements where
many potential credit applicants simply could not qualify?

Sales and credit are directly related, in that, in most cases, stricter credit criteria would always result in
low sales; a loosening up of the credit criteria would almost always results in higher sales. This would
particularly apply in situations where competing products are almost similar in features and attributes
and differ only in brands,