REASONS WHY BUSINESSES PURCHASE CREDIT

Credit is a transaction between two parties in which one, acting as a creditor or lender, supplies the other, the debtor or borrower, with money, goods, services, or securities in return for the promise of future payment. As a financial transaction, credit is the purchase of the present use of money with the promise to pay in the future according to a pre-arranged schedule and at a specific cost defined by the interest rate. In modern economies, the use of credit is pervasive and the volume enormous. Electronic transfer technology moves vast amount of capital instantaneously around the globe irrespective of geographical demarcations.
In a production economy, credit bridges the time gap between the commencement of the production and the final sale of goods in the marketplace. In order to pay labor and secure materials from vendors, the producer secures a constant source of credit to fund production expenses, i.e. working capital. The promise or expectation of continued economic growth motivates the producer to expand production facilities, increase labor, and purchase additional materials. These create a need for long-term financing.
To accumulate adequate reserves from which to lend large sums of money, banks and insurance companies act as intermediaries between those with excess reserves and those in need of financing. These institutions collect excess money (short-term) assets through deposits and redirect it through loans into capital (long-term) assets.
Reasons for Purchasing Credit
In a production economy, credit is widely available and extensively used. Because credit includes a promise to pay, the credit purchaser accepts amount of financial and personal risk. Three strategies summarize the reasons for purchasing credit.
- The lack of liquidity prevents profitable investments at advantageous times.
- Favorable borrowing costs make it less expensive to borrow in the present than in future. Borrowers may have expectations of rising rates, tight credit supplies, growing inflation, and decreasing economic activity. Conversely, profit expectations may be sufficiently favorable to justify present investments that require financing.
- Tax Incentives, which expense or deduct some interest costs, decrease the cost of borrowing and assist in capital formation.
Uses for Credit
A debtor accepts the risks of borrowing to secure something of value, whether perceived or real, profitable or neutral. Borrowing extends one’s purchasing power ad ability to invest capital asset to build wealth. But credit is not only used to produce wealth; credit may be necessitated by psychological and cultural factors as well. The following are some of the most common reasons for using credit:
- Enjoyment: credit has come to finance the enhancement for one’s lifestyle or quality of life through activities and purchases for enjoyment. Activities “profitable” to one’s wellbeing may translate into a more productive economic life, enjoyment includes the financing of a boat, an education, a vacation, a health club, a retreat, etc.
- Utilitarian consumption: With the introduction of credit cards in the 1950s and the increase of home equity debt in the 1980s till date, the financing of daily consumption has greatly expanded.
- Profit and wealth building: The profit incentive plays an important role in the accumulation of capital assets and in wealth building not only for companies – which increase profit through the introduction of capital improvement that must be financed over the long-term – but also for individuals. Home buyers use a similar rationale when buying a house. They expect the purchase of a certain house in a certain location to be more “profitable” than renting or purchasing another house elsewhere. Although a home is not a factory, it is the production backdrop for the capitalist employee selling labor and services.
The granting of credit depends on the confidence the lender has in the borrower’s credit worthiness. Generally defined as a debtor’s ability to pay, credit worthiness is one of the many factors defining a lender’s credit policies. Creditors and lenders utilize a number of financial tools to evaluate the credit worthiness of a potential borrower. Much of the evaluation relies on analyzing the borrower’s balance sheet, cash flow statements, inventory turnover rates, debt structure, management performance, and market conditions. Creditors favor borrowers who generate net earnings in excess of debt obligations and contingencies that may arise. Following are some of the factors lenders consider when evaluating an individual or business that is seeking credit.
- Credit worthiness: A history of trustworthiness, a moral character, and expectations of continued performance demonstrate a debtor’s ability to pay. Creditor give more favorable terms to those with high credit ratings via lower point structures and interest costs.
- Size of debt burden: Creditors seek borrowers whose earning power exceeds the demands of the payment schedule. The size of the debt is necessarily limited by the available resources. Creditors prefer to maintain a safe ratio of debt to capital.
- Loan size: Creditors prefer large loans because the administrative costs decrease proportionately to the size of the loan. However, legal and practical limitations recognize the need to spread the risk either by making a larger number of loans, or by having other lenders participate. Participating lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to ingest a large sum of money.
- Frequency of Borrowing: Customers who are frequent borrowers establish a reputation which directly impacts on the ability to secure debt at advantageous terms.
- Length of commitment: Lenders accept additional risk as the time horizon increases. To cover some of the risk, lenders charge higher interest rates for longer term loans.
- Social community considerations: Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. Examples might include banks participating in low income housing projects or business incubator programs.
……………………………………………………………..