Midterm Exam Flashcards
(from Latin word CREDO, meaning “to believe”) is the trust which allows one party to provide money or resources to another
party wherein the second party does not reimburse the first party immediately (thereby generating a debt), but promises either to repay or return those resources (or other materials of equal value) at a later date
Credit
• Transfer of resources giving rise to
obligation that must be discharged in
the future.
• the ability of a customer to obtain goods
or services before payment, based on
the trust that payment will be made in
the future:
• an entry recording a sum received, listed
on the right-hand side or column of an
account: The opposite of debit.
• the provision of money, goods, or
services with the expectation of future
payment
Definition of Credit
the person or entity that lends money or
extends credit to another party
Creditors
the person or entity that owes money to
another party
Debtors
refers to a natural or juridical person, including any local government unit (LGU), its subsidiaries and affiliates, that applies for and/or avails of a credit facility
Borrower
refers to any loan, credit line, guarantee or any other form of financial accommodation from a submitting entity
Credit Facility
refers to an opinion regarding the
creditworthiness of a borrower or of an issuer of debt security, using an established and defined ranking system
Credit Rating
refers to a summary of consolidated and
evaluated information on creditworthiness, credit standing, credit capacity, character and general reputation of a borrower
Credit Report
refers to information/data concerning the poor credit performance of borrowers, like, defaults on loans, adverse court judgments relating to debts and reports on bankruptcy, insolvency, petitions or orders on suspension of payments and corporate rehabilitation.
Positive Credit Information
What are the items provided by the creditor or lender?
- Goods or products – appliance,
grocery, supplies, etc/ - Services – hotel accommodation,
airfare, car maintenance - Funds – cash loan
- Property – lease or temporary use,
staycation - Rights – temporary use of the right
to use, commercial spaces.
• Represented both as a power and as an obligation
Borrowers Viewpoint
• Signifies the existence of a legal and moral right and an expectation of the fulfillment of a promise
Lenders Viewpoint
The exchange of actual reality against future probabilities
Economist Viewpoint
Creates a legal right in favor of the creditor
against the debtor
Legal’s Viewpoint
What are the basic elements of credit?
• The ability to obtain a
thing of value
• A Promise to pay
• Definite sum of money
• Payable on demand or
future time
• Trust and confidence
• Risk
• Credit is elastic
• It gives rise to creditor-
debtor relationship
purchase goods and services for the purpose of personal use or personal benefit
Consumer Credit
loans used for business
Industrial Credit
when an item purchased is to be used in connection with the business of the obligor
Trade Credit
What are the Functions of Credit?
• Economic function
• Medium of exchange
• To make capital available
• Social function
• Business promotion
What are the 5 C’s of Credit?
- Character
- Capacity
- Capital
- Collateral
- Conditions
refers to borrowers reputation or record
concerning financial matters
Character
the ability to repay a loan or other financial
obligations
Capacity
consist of the person’s real or personal property which can be a strong foundation of credit approval
Capital
something of value, borrowers assets can be used a pledge
Collateral
includes the stability of employment or
business condition or economic condition during the time of loan application
Conditions
A common reason to acquire credit where they
• Fund working capital for
short term
• Fund long term projects
• Fund acquisition or buy
business
Companies
A common reason to acquire credit where?
• Fund purchase of car if
one has no enough
amount to pay it in
cash
• Fund tuition fees of
student doesn’t have
enough cash to pay it
currently
Individual
• To improve the availability of credit to micro, small and
medium enterprises (MSmE)
• To make credit mechanism more cost-effective
• To reduce the excessive dependence on collateral to
secure credit facilities.
Objective of Credit Operations
What are the types of credit?
- Revolving Credit
- Installment Credit
- Open Credit
• A line of credit that has
a cap or credit limit
• A person can use it
anytime until the limit is
reached and then pay
off the credit to use it
again
• Example: Credit Cards
Revolving Credit
• Loans for a set amount
with a predetermined
repayment structure
• Example: housing loan,
car loan, etc
Installment Credit
• Credit that is due in full
each period
• Example, utility bills
Open Credit
An act fixing rates of interest upon loans
and declaring the effect of receiving or taking usurious rates and for other purposes
Act no. 2655 Usury Law
provides for the remedies of a seller in the
contracts of sale of personal property by installments.
Two Installment Default Rule under Civil law (Art.1484, RA
386) – Recto Law
The process of evaluating the creditworthiness of an individual,
business, or any other entity seeking credit.
It involves assessing the ability and willingness of the borrower to
repay debt obligations in a timely manner.
This is important for lenders, as it helps them determine
the level of risk associated with extending credit.
Credit Analysis
refers to the availability of company
resources to meet short-term cash requirements
Liquidity
refers to a company’s long-run financial
viability and its ability to cover long-term obligations
Solvency
involves examining an entity’s
financial statements:
• balance sheet,
• income statement, and
• cash flow statement.
• Analysts assess various financial metrics to gauge the financial
health and performance of the borrower.
• Key areas of focus include liquidity, profitability, solvency, and
efficiency.
Financial Statement Analysis
• Loan agreements and bond indentures often contain stipulations
for maintenance of minimum working capital levels
• Financial analysts assess the magnitude of working capital for
investment decisions and recommendations.
• Government agencies compute aggregates of companies’ working
capital for regulatory and policy actions.
Working Capital Measure of Liquidity
What is the formula for current ratio?
Current Assets/Current Liabilities
The higher the amount of current assets to current liabilities, the greater assurance we have that current liabilities will be paid.
Current Liability Coverage
The larger the buffer, the lower the risk. The current ratio shows the margin of safety available to cover shrinkage in noncash current asset values when ultimately disposing of or liquidating them.
Buffer against Losses
The current ratio is relevant as a measure of the margin of safety against uncertainties and random shocks to a company’s cash flows. Uncertainties and shocks, such as strikes and extraordinary losses, can
temporarily and unexpectedly impair cash flows
Reserve of Liquid Funds
What are the parts of current ratio?
• Cash and cash equivalents
• Marketable Securities
• Accounts Receivable
• Inventories
• Prepaid Expenses
Cash held by a well-managed company is primarily of a precautionary reserve intended to guard against short-term cash imbalances.
Cash and Cash Equivalents
Cash in excess of the precautionary reserve is often spent on investment securities with returns exceeding those for cash equivalents.
Marketable Securities
A major determinant of accounts receivable is sales. The relation of accounts receivable to sales is governed by credit policies and collection methods.
Accounts Receivable
Like receivables, the major determinant of inventories is sales or expected sales. Sales initiates conversion of inventories to cash
Inventories
These are expenditures for future benefits. Since these benefits are typically received within a year of the company’s operating cycle, they preserve the outlay of current funds
Prepaid Expenses
What are the focus of Current Liabilities?
• Accounts Payable
• Accrued Expenses
• Taxes Payable
• Salaries and Wages Payable
• Taxes Payable
The analysis must look for “management” of the current ratio, also known as window dressing.
Toward the close of a period, management will occasionally press the collection of receivables, reduce inventory below normal levels, and delay normal purchases. Proceeds from these activities are then used to pay off current liabilities.
Ratio Management
A frequently applied rule of thumb is if the current ratio is 2:1 or better, then a company is financially sound, while a ratio below
2:1 suggests increasing liquidity risks.
• The 2:1 norm implies there are $2 of current assets available for every $1 of current liabilities or, alternatively viewed, the value of current assets can in liquidation shrink by as much as 50% and still cover current liabilities.
• A current ratio much higher than 2:1, while implying superior coverage of current liabilities, can signal inefficient use of
resources and a reduced rate of return
Rule of Thumb Analysis
What is the formula for Quick Ratio?
Cash + Cash Equivalents+ Market Securities+ Accounts Receivable/Current Liabilities
measure company profitability and performance
Income Statement
A measure of the likelihood of collection the proportion of receivables within terms of payment
Accounts Receivable Turnover
What is the formula for Accounts Receivable Turnover?
Net Sales on Credit/Average Accounts Receivable
It measures the number of days it takes, on average, to collect accounts receivable based on the year-end balance in accounts receivable.
Days’ Sales in Receivables
What is the formula for Days’ sales in receivables?
Accounts Receivable÷sales/360
this condition demands corrective managerial action,
Poor Collection Efforts
It reflect on both the quality and liquidity of
accounts receivable and demand judicious
managerial action.
• Delays in customer payments.
• Customers in financial distress.
measures the average rate of speed at which inventories move through and out of a company.
Inventory Turnover Ratio
What is the formula for inventory turnover ratio?
Cost of goods sold/Average Inventory
This ratio tells us the number of days required to sell ending inventory assuming a given rate of sales
Days’ Sales in Inventory
What is the formula for Days’ Sales in Inventory?
Ending Inventory÷cost of goods sold/360
receivables with the days to sell inventories to obtain the time interval to convert inventories to cash
Operating Cycle
are important in computing both working capital and the current
ratio for two related reasons:
1. These are used in determining whether the excess of current
assets over current liabilities affords a sufficient margin of safety.
2. These are deducted from current assets in arriving at working
capital.
Current Liabilities
A measure of the extent to which companies “lean on the trade”
Average Payable Days Outstanding
This ratio indicates the speed at which a company pays for purchases on account.
Accounts Payable Turnover
What is the formula for Accounts Payable Turnover?
Cost of goods sold/Average Accounts Payable
• Provide information about the cash receipts and payments of an entity during a period.
• Provide important information that complements the statement of comprehensive
income and balance sheet.
• Provide important information from a cash-basis perspective
Purpose of a Statement of Cash Flows
Transactions and events that enter into the determination of net income
Operating Activities
Transactions and events that involve the purchase and sale of securities, PP&E, and
other assets not generally held for resale making and collecting of loans
Investing Activities
Transactions and events whereby resources are obtained from, or repaid to, owners and
creditors.
Financing Activities
• The static nature of the current ratio and its inability (as a measure of liquidity) to recognize the importance of cash flows in meeting maturing obligations has led to a search for a dynamic measure of liquidity.
Cash Flow Measures
What is the formula for cash flow ratio?
Cash flow ratio= operating cash flow/current liabilities
