PART I

HOW CREDIT WORKS

Chapter 1: Credit in the Business World

Chapter 2: Credit in the Company
Chapter 3: Organizing the Credit Department
Chapter 4: The Credit and Sales Partnership
 1 Credit in the Business World
Overview
Credit is a privilege granted by a creditor to a customer to defer the payment of a debt, to incur debt and defer
its payment, or to purchase goods or services and defer payment. This chapter provides an introduction to the topic
of credit. It explores the history of credit, the primary reasons credit is offered and presents an overview of the
credit process.
Additionally, the types of credit are defined and discussed. Lastly, the chapter provides an overview of the
Federal Reserve System (Fed) and how it controls the U.S. economy.

THINK Q. How would business be conducted in a world without credit?

ABOUT
Q. A new tech startup and a company that is speculated to have poor financial
THIS
management both place an order with your company, what factors would
you take into account when extending credit?
Q. How does credit change based on the industry or the economic and
business conditions?

Chapter Outline
DISCIPLINARY
CORE IDEAS 1. A Brief History of Credit 1-2
2. Primary Reasons to Offer Credit 1-4
Aer reading this chapter, the reader should
understand: 3. Elements of Credit 1-5
The historical development of credit. 4. Canons of Business Credit Ethics 1-8
The primary reasons credit is offered. 5. The Credit Process 1-10
The important elements of credit. 6. Types of Credit 1-11
The credit process and where credit fits 7. The Federal Reserve and the 1-15
into a business cycle. U.S. Payment System
The different types of credit. 8. Check Processing 1-21
The Federal Reserve System and its
9. Electronic Funds Transfer 1-22
impact on the economy.
10. Federal Deposit Insurance 1-23
Corporation
11. Online Business Banking 1-23

Chapter 1 | Credit in the Business World 1-1

A Brief History of Credit
The idea of exchanging goods or services in return for a promise of future payment developed only after centu-
ries of trade; money and credit were unknown in the earliest stages of human history. Nevertheless, as early as 1300
B.C., loans were made among the Babylonians and Assyrians on the security of mortgages and advance deposits. By
1000 B.C., the Babylonians had already devised a crude form of the bill of exchange so a creditor merchant could
direct the debtor merchant in a distant place to pay a third party to whom the first merchant was indebted. Install-
ment sales of real estate were being made by the Egyptians in the time of the Pharaohs.
Traders in the Mediterranean area, including Phoenicia, Greece, Rome and Carthage, also used credit. The vast
boundaries of the Roman Empire encouraged widespread trading and a broader use of credit. In the disorganized
period that marked the decline and fall of the Roman Empire, credit bills of exchange and promissory notes were
widely used to reduce the dangers and difficulties of transferring money through unorganized trading areas.
During the Middle Ages, a period which spanned 1,000 years from about 500 to 1500 A.D., credit bills were
essential to the trading activities of the prosperous Italian city-states. Lending and borrowing, as well as buying and
selling on credit, became widespread practices; the debtor-creditor relationship was found in all classes of society
from peasants to nobles. A common form of investment and credit, especially in Italy, was the “sea loan” whereby
the capitalist advanced money to the merchant and thus shared the risk. If the voyage was a success, the creditor
got the investment back plus a substantial bonus of 20 to 30 percent; if the ship was lost, the creditor stood to lose
the entire sum.
Another form of credit was the “fair letter,” which was developed at fairs held regularly in the centers of trading
areas during the Middle Ages. The fair letter amounted to a promissory note to be paid before the end of the fair or
at the time of the next fair. It enabled a merchant, who was short of cash, to secure goods on credit. This gave the
merchant time either to sell the goods brought to the fair or to take home and sell the goods that had been pur-
chased on credit.

Credit in Early America

The discovery of the New World provided new opportunities for the growth of capitalism and the expansion of
credit. The first recorded use of open credit in early America took place with the establishment of the first perma-
nent colony in New England. In September 1620, the Mayflower set sail from England for Virginia. Because of bad
weather and navigational errors, the Pilgrims ended up off the coast of Cape Cod and eventually established the
village of Plymouth in Massachusetts. Not only was the journey itself was a tremendous achievement, its financing
was as well.
The Pilgrims had spent three years of arduous negotiations in England attempting to raise the funds necessary
for the trip. A wealthy London merchant financed the trip and provided for “all credit advanced and to be advanced.”
In return, the Pilgrims contracted to work for seven years. At the end of that period, payment would be made to the
creditors based on the size of the individual investment.
The original credit of £1800 could not be paid at the end of seven years, so an alternative arrangement was
agreed upon: £200 to be paid annually for a term of nine years. This arrangement had to be renegotiated and finally,
after 25 years, the last payment was made. This was the first example of credit in early America.
To finance the American Revolution, the Second Continental Congress made efforts to finance the Army of the
United Colonies. The Congress had only three alternatives: borrow the money from sympathetic countries abroad,
which was an impossible task since the Colonists’ credit in the world stood at zero; impose taxes, which was unpop-
ular and the very cause that had brought about the American Revolution; or issue bills of credit.
In June 1775, the Continental Congress authorized the printing of $2 million in various denominations ranging
from one dollar to eight dollars. Trouble for the Continental currency began almost at once; each note had to be
hand signed, which was not a simple task considering there were 49,000 of them. Counterfeiting of the currency
was rampant. The principle behind the Continental currency was, in essence, a promise to pay the final bearer, at
some point in the future, the face value in Spanish coins, the coins in widest circulation at that time.

1-2 Principles of Business Credit

 In 1783, the Treaty of Paris was signed bringing an official
end to the war and official recognition of the United States by Transition from Barter
England. Trading resumed and American importers and whole-
It has been said that the growth of specializa-
salers extended generous terms to their customers. Generally,
tion is one of the distinguishing features of
sales were made on terms of 12 months, but even where six- or
modern society. That may be so, but special-
nine-month terms were offered, it was not uncommon for an
ization surely began far back in the midst of
account to remain unpaid for a much longer period, sometimes time when one of our ancestors decided that
up to 24 months or more. he had just had too much! He couldn’t do
With the restoration of pre-Revolutionary trade customs everything himself—hunt, fish, shape axe
and habits, credit references assumed importance, although in heads, fashion spears, and gather wood, salt
most instances, proper information was still lacking. Some pro- and berries. Perhaps it was at that time that
spective purchasers took the precaution of using the names of the revelation occurred. He was a good fish-
prominent people they knew when placing orders on credit. erman; his neighbor was not.
While credit references sometimes accompanied orders, in
But that neighbor certainly knew how to turn
most cases merchants took their chances. Terms of sale, as they
out axe heads! He could give some of the
developed during the 1800s, reflected the changes in the rap- surplus of fish to the neighbor in exchange for
idly expanding economy. The 12-month period, which had pre- an axe head or two. Thus, the birth of barter.
vailed, gradually became shorter. By the 1830s, the average
term of sale was about six months. A particularly fascinating type of barter, and
Hard financial times hit the country in the mid-1830s. The one that implicitly established one as a credi-
population was rapidly growing and business was expanding. tor, was practiced by Native Americans: a
form of exchange called potlatch. The social
The sale of land on credit went virtually unchecked and the
status of the giver rose in proportion to the
banking system was not centralized. By the summer of 1837,
magnificence of the gifts offered—and the
bank after bank closed its doors and thousands of businesses
accompanying influence that was gained by
went into bankruptcy. The financial panic of 1837 saw the having others in your debt.
beginnings of the Mercantile Agency, established in 1841 by
Lewis Tappan. It was this credit information agency that even- Simple barter, useful as it was, had some
tually became Dun & Bradstreet and helped transform credit limitations: If your neighbor didn’t want any of
and, with it, the course of American commerce. your fish, you had to find someone who did—
and fast. Commodity money, which devel-
oped out of simple barter, overcame this dif-
ficulty. Commodity money was something
Comprehension Check that had assumed some accepted value. As a
Explain the reasons credit has evolved. portable store of value, it could be exchanged
for a wide variety of items. Cowrie shells, for
example, were used in China 3,500 years
The story of American credit was not solely influenced by ago and more recently in New Guinea, Africa,
Dun & Bradstreet. Another organization important for credit many Pacific Islands and in various parts of
professionals worldwide was formed in 1896 in Toledo, Ohio. A the Middle East. Cattle were, and still are,
group of credit executives, representing a hundred or so of their used as money in parts of the world. Salt was
colleagues, organized a national association for credit profes- also a common medium of exchange (salt
sionals, the National Association of Credit Men. Their exchange bars were still being used as money as
of credit information was initially conducted on local and recently as the 1920s). Early American colo-
nists borrowed an idea from Native Ameri-
regional levels. The association expanded into the National
cans—wampum (elaborate and beautiful
Association of Credit Management (NACM), which today with
strings of beads)—and declared it legal ten-
its network of Affiliated Associations, represents more than
der in Massachusetts in 1637. Other exam-
14,000 credit professionals worldwide. NACM’s purposes and ples abound: fish hooks, feathers, amber,
objectives are: rice, human skulls, ivory, drums, nails, hoes
and furs, to name but a few.

Chapter 1 | Credit in the Business World 1-3

 • To promote honest and fair dealings in credit transactions.
• To ensure good laws for sound credit.
• To foster and facilitate the exchange of credit information.
• To encourage efficient service in the collection of accounts.
• To promote and expedite sound credit administration in international trade.
• To encourage training for credit work through colleges, universities, self-study courses and
other means.
• To foster and encourage research in the field of credit.
• To disseminate useful and instructive articles and ideas with respect to credit management
techniques.
• To promote economy and efficiency in the handling of estates of insolvent,
embarrassed or bankrupt debtors. Comprehension Check
• To provide facilities for investigation and prevention of fraud. Explain why organizations
like NACM evolved.
• To perform other such functions as the advancement and protection of
business credit may require.

Primary Reasons to Offer Credit

Business or trade credit has been part of the U.S. business scene for hundreds of years—and the use of credit in
the purchase of goods or services is so common that it is taken for granted. Trade credit is, and continues to be, a
very important source of funds for firms. It provides more financing to businesses than does commercial borrowing
or corporate bond financing. Without business credit, the economic system would not exist.
The primary reason for a company to offer credit terms to customers is to accommodate the sale of goods and
services in order to create revenue. The principal reasons companies offer credit are:

• Increase Sales. Extending credit to buyers often involves a trade-off between holding
inventory or holding accounts receivable.
• Competition. Matching a competitor’s credit terms may be a sales necessity.
• Promotion. A business may offer special credit terms as part of a promotional program for
a product.
• Credit Availability. Some buyers may not have access to any other forms of credit. In tight
credit times, seller trade terms or financing may be necessary.
• Convenience. Trade credit provides benefits not easily obtained from other payment
arrangements. One of the biggest benefits is the simple convenience of paying for hundreds
of purchases in a single transaction.
• Demand. Credit is extended in response to customer demand for a com-
pany’s products or services. This implies that the sale may or may not take Comprehension Check
place without the extension of credit. List and explain the reasons
• Price. The granting of trade credit is an aspect of price. The time that the credit is offered.
buyer gets before payment is due is one of the dimensions of the product,
such as quality and service, which determines the attractiveness of the Explain why a sale may not
product. Like other aspects of price, the firm’s terms of sale and credit- occur without credit.
granting decisions affect its sales volume.

1-4 Principles of Business Credit

Elements of Credit
Several essential points are always included in any definition of credit. First, there must be an exchange of values
which sets up the transaction. Goods or services are obtained for a promise to pay, and payment is made when it
comes due. This introduces the second factor: futurity and its companion, trust. The credit sale relationship between
customer and supplier is based on trust and mutual need. The very derivation of the word “credit” from the original
Latin credere, to believe or trust, graphically describes the entire process of credit as a matter of mutual trust and
confidence. The buyer selects the supplier on the basis of its reputation as a source of a quality good at an accept-
able price. The supplier accepts the order and extends the credit necessary to facilitate the sale if it believes the
customer will honor the contract by paying the invoice according to the terms agreed. Thus, credit can be appropri-
ately described as the transfer of economic value now, on faith, in return for an expected economic value in the
future.
Where goods or services are exchanged immediately for cash, there is no futurity, no trust and no need for the
seller to have confidence in the buyer. None of these is needed since economic payment is made at the time of
purchase.
Credit sales represent an extension of the cash inflow timeline. When credit is granted, the seller does not
require cash at the time of the sale, but rather permits payment to be made at a specific date in the future. When a
payment is offered, the seller must decide whether or not to accept it. Many times company policy will guide the
seller’s action, while at other times a snap judgment may be necessary. Since the transaction involves futurity, trust
and confidence, the credit concept is involved. The futurity of non-cash payments is short—just long enough for the
payment to clear. Trust and confidence, however, are just as significant in this example as they are with longer
terms. Once the seller has transferred goods to a buyer, legal steps are necessary to repossess these goods.
When unsecured credit terms are offered, the seller gives up goods or provides services in exchange for the
promise of the buyer to pay at a specific future date. The seller is convinced that payment will be received when it
is due—and that the buyer can be trusted. In a sale made on 30 or 60 day terms, for instance, the futurity aspect of
credit is important; and as selling terms lengthen, the seller’s analysis of the buyer’s ability to pay on or by the due
date becomes increasingly important.
There is no doubt that selling on credit is more costly than selling for cash.
Those costs include the cost of the credit department, the investment of com- Comprehension Check
pany funds in receivables, discounts for early payments, and the cost of convert- What does the Latin term
ing receivables to cash and collecting bad debts. All of these factors comprise credere mean?
the cost of credit. No matter how great these costs, however, they are more
than offset by distinct sales advantages. By offering credit terms, the seller can Explain why selling on credit
build a greater customer base, make more efficient use of production facilities, is more expensive than cash,
create greater goodwill, expand geographical markets, accept marginal risks, but ultimately beneficial.
earn incremental profits and ultimately realize a greater return on investment.
There are several important elements of credit:

• Risk of Nonpayment. The purchaser may default in making any or all of the payments due
to the seller.
• Timing. When credit is offered, the seller must wait for payment, even if that payment is
received on time. This increases the risk of losing the use of funds that are tied up in
financing the credit transaction or, if a payment is late, in carrying or financing the past-due
customer.
• Security. As a means of gaining partial or full protection for the credit transaction, a seller
may require the purchaser to pledge a form of collateral or provide a financial guarantee.
This can be accomplished by pledging an asset, providing a personal, corporate or bank
guarantee or entering into a security agreement.

Chapter 1 | Credit in the Business World 1-5

 • Extra Costs. The seller incurs expenses with granting credit, such as carrying receivables
and the costs associated with the collection process.
• Legal Aspects. Federal and state laws have been enacted that affect both the credit grantor and
debtor. Both businesses and consumers must be aware of applicable state and federal laws.
• Economic Influences. Changes in economic conditions, such as the rate of inflation and
currency value fluctuations, can have strong effects on credit sales. For example, in infla-
tionary times, a seller will not want to wait too long before getting paid and will likely
impose stricter credit policies.

Companies are exposed to many changes: political and demographic changes, recessions, inflation and interest
rate fluctuations. Companies within a particular industry confront additional risks relating to technological changes,
shifting competition, rapid growth, regulation and the availability of raw materi-
als and labor. Management competency, litigation and the company’s strategic
Comprehension Check direction are additional sources of risk. All of these factors affect a company’s
List and explain the important operating performance, net income and cash flows, which affect the buyer’s abil-
elements of credit. ity to pay. Credit in its broadest sense is based on the components of trust, risk,
economic exchange and futurity.

The Five Cs of Credit

Credit analysis is traditionally based on what is known as the Five Cs of Credit: (1) Character, (2) Capacity, (3)
Capital, (4) Collateral and (5) Conditions. The Five Cs of Credit provide the credit manager or analyst with a frame-
work for conducting a controlled investigation process and, therefore, deliver a credit evaluation that considers
each component of credit risk associated with credit approval.
But are we limited to only the Five Cs listed? Consider the changes over the years in various industries not to
mention the economy at large. Competition is also important since the credit analysis process can be influenced by
terms or conditions the competition is offering in the marketplace. In addition, the credit professional must exercise
Common Sense; if, on the surface, something doesn’t seem right, then more questions should be asked, more infor-
mation gathered and a harder look taken.
In each case the credit professional must measure the business credit account against every one of the Cs before
issuing credit approval or a final recommendation. Sometimes the degree of credit
investigation can depend on the customer’s or potential customer’s size or impor- Comprehension Check
tance to the credit grantor and to the credit grantor company’s established policy What are the Five Cs
and procedures; thus, credit policy can require certain levels of credit investigation of Credit?
for different sizes or types of accounts. Therefore, it is possible for one C component
to outweigh other C components.

Character
Character refers to the willingness of a debtor to pay its obligations and imputes a level of ethics, integrity, trust-
worthiness and quality of management that is provided or available to the business customer (proprietorship, cor-
poration, etc.). Examining the business character of a customer requires that the credit professional learn about the
previous business background of the people who own, manage or preside over that entity. Management that have
been, or are currently in business on their own, or who have been officers of corporations, can be evaluated on the
success or failure of the business in which they have been or are currently involved. A company with a long-standing
record of operation without litigation or financial difficulty indicates a favorable business record. On the other hand,
a company with a record of litigation or bankruptcy could suggest a possible risk. In both cases, a company reflects
upon the people who managed it during times of success, setback or even failure. If a business applying for business
credit involves ownership by a principal who has been involved in a business failure, the credit professional should
determine the cause and then consider the reason in any subsequent credit decision. A previous business holding

1-6 Principles of Business Credit

that was destroyed as a result of a force of nature could have a bearing on a decision to grant credit that is far dif-
ferent from a previous business holding that failed because of mismanagement or negligence.
When questions linger about a principal (or personal guarantor), it is reasonable to obtain a personal (consumer)
credit report on the principal of the business that is applying for business credit. A “permissible purpose” and the
written consent of the subject of the inquiry are required to obtain a consumer credit report.
Other Character considerations:

• Is this business able to redefine itself in a changing market?

• What is the impact of technological evolution on this business?
• How willing is the customer to share information?
• How diligently does the customer complete the credit application?

Capacity
Capacity deals with the inclination or propensity of a business to operate profitably and its ability to pay trade
creditors, banks, employees and others as those debts become due. Capacity can be substantiated by a customer’s
ability to generate positive cash flow and by current and previous acts and deeds. The credit professional needs to
know how the company handles large volume orders, exacting specifications or tight delivery schedules. Can the
company grow and is it able to provide or obtain the needed capital and the necessary financing?

Capital
The value of a customer’s business in excess of all liabilities and claims is referred to as its equity or net worth,
and represents its financial strength in terms of Capital. Capital does not equate to cash; it is the amount of wealth
available, in several forms, to be employed by a business in the production of more wealth—in the form of prod-
ucts/inventory purchased for resale, manufactured goods, or the purchase of permanent and fixed assets such as
machinery or buildings. In evaluating Capital, the credit professional seeks to determine whether the customer pos-
sesses the ability to satisfy its obligations and lessen credit risk. This approach is different from the first “C,” Charac-
ter, which seeks to judge if the account is willing to pay. This factor highlights a company’s financial condition and
trend of operations. Each case is judged on its own merit, since many factors affect financial condition. Some indus-
tries need a large investment in fixed assets; others require only a minimum investment in machinery and fixtures.
Similarly, some lines of business must have large amounts of ready cash and liquid assets to meet seasonal operat-
ing expenses, while others may rely on regular cash inflows to meet maturing debts.

Collateral
If the cash flow of a business customer is not adequate, the credit manager can request a second source of
repayment called Collateral: property that may be pledged as security for the satisfaction of a debt. The type of
property that can be pledged includes equipment, buildings, accounts receivable, stocks and bonds, inventory and
other tangible assets that, once pledged, can be seized and sold by the creditor if the company defaults on the debt.
The credit manager must determine whether the business has additional resources in the form of equity in the
assets pledged that can be liquidated for payment. Additionally, the credit professional must discover if the poten-
tial collateral is unencumbered or if it has been pledged to, and secured by, other creditors. If the asset pledged is
not free and clear, then the creditor taking the security interest may be at the mercy of other creditors who took the
same asset as security ahead of later entries. The position of the secured party is based on the legal principle of “first
in time, first in right,” which means that liquidation of security interests is based on what priority the security instru-
ments were taken and filed.
Assets can be pledged voluntarily with the use of security agreements and filings. This type of pledge is best
administered in advance of a credit sale. The security agreement should carefully identify items pledged as collateral.
Assets can also be obtained involuntarily using such legal instruments as liens or judgments then executed to
liquidate property taken and used for repayment. Encumbering assets in this manner is usually after the fact of the

Chapter 1 | Credit in the Business World 1-7

credit sale, is not by agreement but rather by a function of state law, is not friendly and often involves additional
time and expense.

Conditions
External events, occurrences, phenomena and factors that may interrupt or otherwise disturb the normal flow
of business are Conditions the credit professional considers when examining a new or existing customer’s credit.
Some examples of Conditions are:

• National, regional or local economic environment.

• State and federal government regulations.
• Weather phenomena (hurricane, ice storm, drought, flood, etc.).
• Catastrophic events (fire, explosion, terrorist attack, etc.).

If providing credit to a customer who sells internationally, then other Conditions must be considered such as the
stability of a foreign country’s government and/or currency exchange rates.
The credit professional considers how sensitive the company’s sales are to these Conditions. Will the company’s
sales fall dramatically or will they be relatively unaffected if faced with situations as described above? Companies
with stable sales that are not tied closely to the overall economy (e.g., food and essential life products) are generally
looked upon more favorably by creditor grantors. Similarly, the likelihood of a satisfactory credit experience is
greater when the subject is in an industry that is in a period of growth.
It is important for the credit professional to know industry cycles and if a customer’s industry is subject to peri-
ods of highs and lows. The credit professional will look more favorably on a
business that demonstrates increasing sales, profits and net worth. Essentially, Comprehension Check
two words may summarize Conditions: demand for the product or service the Why might one C be considered
customer offers, and circumstances that affect the business that are beyond more important?
management’s control.

Canons of Business Credit Ethics

The cornerstone of the global business economy is the extension of commercial credit. As such, business credit
executives, as the guardians of commercial receivables, play the vital and critical role of ensuring the flow of com-
mercial goods and services that support world commerce.
In fulfilling their professional duties, business credit professionals pledge to conduct their duties within the con-
straints of law and to not maliciously injure the reputation of others. Further, business credit professionals pledge
themselves to the highest professional standards and principles and to guarding and securing, in confidence, infor-
mation obtained for the sole purpose of analyzing and extending commercial credit.
Credit professionals pledge to:

• Adhere to the highest standards of integrity, trust, fairness, personal and professional
behavior in all business dealings.
• Negotiate verbal or written credit agreements, contracts, assignments, and/or transfers
with honesty, fairness, and due diligence to and for the benefit of all parties.
• Render reasonable assistance, cooperating with impartiality and without bias or prejudice,
to debtors, third parties, and other credit professionals.
• Exchange appropriate, historical and current factual information to support the process of
independent credit decisioning.

1-8 Principles of Business Credit

RWP 1-1 Real World Perspectives
FIVE Cs of credit
When investigating a new customer or performing a review on a current customer who does not have financials to investigate,
turn to a process that was employed nearly a half-century ago. The process is known as the 5 Cs of Credit: Character, Capi-
tal, Capacity, Conditions and Collateral.

A customer’s character will define their willingness to pay for the product or service being provided. To develop an opinion on
a customer’s character, it is advantageous to review their management staff and see if they have been in the same form of
business for a long period of time, or if this is their first time in the industry. If the business history is short, it is advisable to
move with caution. Some of the steps a credit professional could take in this situation are to visit the customer, see how the
business is set up and talk with the management to see what their growth plan or business plan is. Ask them if you can review
their financials while you are there and discuss any flags that you may find. If the credit professional is unable to visit, a credit
report could be pulled along with the references they provide to see what the payment history of the company is. Also check
if the company has any judgments against them, if any of their accounts have been placed for collections, or if any liens have
been established. When the credit professional performs the bank reference check, a review of the NSF checks that are
reported and how long the bank account has been opened can also assist in defining character.

Unlike character, capital determines if the customer is able to pay their debts in a timely manner. Ideally, it is beneficial to have
financial statements available for review. However, a credit professional is able to look at other factors if they are not available.
A review of the customer’s life cycle can define when the cash flow is at a high for the company and their expenses are at a
high (i.e., a seasonal operation or companies that do not make payments at quarter end). A credit professional could use the
third-party credit data that was pulled to see if there are any judgments or liens that might become due during the time frame
when a payment would be expected. If the credit professional’s industry has an Industry Trade Group, it would be beneficial to
see how the company being reviewed is defined in the trade group ranking and see how they compare with companies that
others in the industry sell to. If it is an existing customer and a review is being done, what the credit analyst has experienced
with the customer could be taken into consideration when reviewing capital. If the credit analyst has developed a rapport with
the accounts payable analyst, they may have additional insights as to how the company is performing based on previous con-
versations.

The capacity of a company shows the credit professional whether the customer has the proper legal structure to allow the
corporation to continue making payments to the debtor. This can relate to the review of management that was performed in
the character section by looking at the managers in charge of the three key business operations: marketing, financial and
production. From the marketing standpoint, the credit professional could review the different business segments that the
company is involved in as well as the company’s marketing priority. From the financial standpoint, the manager that is in place
can be researched to see what other companies they have been tied to. Look at the history of those companies and under-
stand their general overall strategy. From the production standpoint, the credit professional could review the level of automa-
tion the company has to see if the it can keep up with changing demands of production. If the information on the managers is
not available on the company’s website, perhaps an Industry Trade Group would be able to provide the information, or use
third-party credit ratings or certain websites such as [Link]. Once the information about the managers is found, a great
way to see their professional history and review the companies they worked for is to look on their LinkedIn profile.

When considering conditions, the general economic conditions that currently exist in the country where the company would
be doing business are important. The credit professional would review the overall performance of the industry that they are
operating in to help determine the amount of risk that is acceptable. A review of what the selling margin would be could pos-
sibly allow certain levels of risk to be overlooked, or if the customer also sells product to your company, a review of the pay-
ables due to them could help mitigate risk of open receivables.

Lastly, employing collateral would allow the credit professional to obtain a letter of credit as a payment option, a personal or
a corporate guarantee from the company, any liens on equipment that might be able to be placed, and again, as in conditions,
any payable that your company may owe them to offset any debtor obligation. If the credit professional is able to offset any
liability with these options, the review of the customer could become easier.

Lisa Ball, CCE, Dawn Dickert, CCE, Kathie Knudson, CCE, Stacey Parker, CCE
Graduate School of Credit and Financial Management class of 2016

Chapter 1 | Credit in the Business World 1-9

 • Exercise due diligence as required to prevent unlawful or improper disclosure to
third parties.
• Disclose any potential conflict in all business dealings.

Further, credit professionals acknowledge the importance of, and shall promote the benefits of, continued
improvement of their knowledge, skills, and expertise in business credit. The pursuit of knowledge will support the
strategic advancement of the commercial credit function as it leads businesses to profitability and growth.

The Credit Process

In simple terms, the credit process begins with a buyer (a company or individual consumer) deciding to purchase
a product or service from a seller that either makes or provides a product or service. The buyer offers a means of
trading value, or a medium of exchange, for the goods or service. Cash is most readily accepted by the seller, but the
seller may also offer a form of deferred payment or credit.

The Credit Process

n Sales makes contact and order is taken.
n Credit department reviews customer for creditworthiness.
n Goods or service delivered on credit.
n Payment is made on time/within terms.

Credit is part of a company’s

Figure 1-1 Operating Cycle
operating cycle. An operating cycle
can be defined as the period of time
unt Re
between the acquisition of material,
Acco d Ma ceiv
k ite ter e
labor and overhead inputs for produc-
B an red ial
tion and the collection of sales receipts. C s
During the operating cycle, a manufac-
turer is both a debtor and a creditor. e P
Cust yme ends

ro

Consider a typical operating cycle for a

tion Sta

duct

Payments
nt
omer S

manufacturer: the operating cycle Operating

Send
ion St

begins when the manufacturer pur- Cycle

Pa

llec

chases raw material from a supplier.

ag
o

The purchase of raw material is usu-

C

e
ally a business credit transaction. The
material is converted into goods dur-
nt

ing the production stage, and the Pr S el ou

od l A cc d
manufacturer must pay its supplier for uct B a n k e b it e
the material. The manufacturer then D
sells the finished goods to a customer,
who ultimately pays for the goods that
were purchased on credit during the collection stage.
The purchaser becomes the debtor or user of credit, while the seller becomes
Comprehension Check
the creditor or grantor of credit. The purchaser’s ability to obtain a product or
service based on its promise to pay at a later date is called creditworthiness. Define operating cycle.

Why will a manufacturer be

both debtor and creditor at
any given time?

1-10 Principles of Business Credit

 Figure 1-2 Credit and Collection Cycle

Collection Process

Additional Terms of Sale

Credit Process

Seller or Creditor Cash Application

Order Processed and Shipped
Seller:
cash order Automatic or Buyer receives
Buyer
computer-based goods or services
credit approval
ing er in g
ist
ex stom ndin
cu d sta

EOM
Seller:
o
go Credit Investigation
Debtor receives
Buyer • Unusual order
credit goods or services
• New customer
application • Account review

MOM
credit rejected
offered new terms

Prox
Payment Payment
to Seller CIA CWO CBD COD to Creditor

cash order seeking credit

Types of Credit
Because of its different uses, credit can be broadly classified as either public credit or private credit. Public
credit, also known as government credit, is credit extended to or used by governments or governmental divisions,
agencies or instrumentalities. Private credit is extended to or used by individuals or businesses to carry on the
exchange of goods and services in the private sector.

Public Credit
Public credit includes the extension of, or borrowing by, any governmental unit. All levels of government—fed-
eral, state and local—borrow money to meet public needs, including financing the cost of schools, highways, health
and social welfare and military preparedness. Governments buy a wealth of products and services such as tanks,
planes, food, office supplies, books, computer equipment, labor, electricity and so forth. Private sector businesses
provide nearly all of these products and services. In all cases where financing needs exceed revenue, governments
must draw upon their borrowing capacity. This is usually done by the issuance of state, municipal or federal bonds,
or in the case of the federal government, through the issuance of shorter-term Treasury bills and notes. Currency
itself can be regarded in a sense as a credit obligation of the federal government, though it is usually not classified
as such. Analysis of public debt is usually made on the basis of a government’s
powers of future taxation.
On the other side of the equation is federal and state lending, which often has Comprehension Check
public policy objectives. Some of these loans include disaster loans, loans by the Define and give an example
U.S. Small Business Administration, USDA business and industry loan programs of public credit.
and many others.

Chapter 1 | Credit in the Business World 1-11

Private Credit
Private credit is extended to or used by individuals or businesses to carry on the exchange of goods and services
in the private sector. Private credit can be divided into five broad categories:

1. Investment credit.
2. Consumer credit.
Comprehension Check
3. Agricultural credit.
What are the major types of
4. Business credit. private credit?
5. Bank credit.

Investment Credit
This refers to the placement of funds in productive assets to earn a profit. Investment credit can be defined as
the long-term borrowing of large amounts of money to finance productive assets. It consists primarily of loans made
to governments or businesses to raise capital to pay for expansion, modernization or public projects such as high-
ways or schools. A borrower may be an institution, a corporation, the U.S. Treasury or a state, city, town or county;
an investor is a lender who can buy bonds issued by U.S. companies, the U.S. Treasury or states, counties and cities.
Bonds are loans that investors make to corporations and governments through which borrowers obtain the cash
they need while lenders earn interest. Corporate bonds, usually applied to longer-term debt instruments, with
maturity of at least one year, are higher risk than government bonds and thus higher yielding.
Companies often prefer to offer a bond rather than to issue stock to raise money because issuing additional
stock may lessen the value of shares already owned by investors. Unlike stockholders who have equity in a com-
pany, bond holders are creditors. Corporate bonds are listed on the New York Stock Exchange. Since governments
are not profit-making entities and cannot issue stock to raise money, bonds are the primary way for governments
to raise money to fund capital improvements.
Bonds, or fixed-income securities, are generally long-term (more than 10 years) securities that pay a specified
sum (called the principal) either at a future date or periodically over the length of a loan, during which a fixed rate of
interest may be paid on a regular basis. Every bond has a fixed maturity date when the bond expires and the loan
must be paid back in full. The interest a bond pays is also set when the bond is issued. The rate is competitive, which
means the bond pays interest comparable to what investors can earn elsewhere. As a result, the rate on a new bond
is usually similar to other current interest rates, including mortgage rates.
The word “bond” once referred to the piece of paper, which described the details of a loan transaction; the term
is used more generally to describe a vast and varied market in debt securities.
Asset-backed bonds, created in the mid-1980s, are secured or backed up by specific holdings of the issuing cor-
poration such as equipment or real estate.
Debentures are the most common corporate bonds. They are backed only by the financial strength or standing
of the organization issuing it, rather than by any specific assets. A debenture buyer relies on the issuer’s faith and
credit as the only assurance of being paid the interest and principal.
Secured bonds have specific titles attached to them, such as mortgage
Comprehension Check
bonds, equipment and trust certificates and collateral trust bonds. Mortgage
What is the most common type
bonds are secured or collateralized with specific corporate assets such as real
of corporate bond? List its
estate (land and buildings). Mortgage bonds are backed by a pool of mortgage
characteristics.
loans. Equipment trust certificates (ETC) are bonds issued to pay for new
equipment, secured by a lien on the purchased equipment. ETCs are frequently What is the difference between
issued by airlines, railroads and shipping companies to finance the purchase of a secured bond and a
railroad freight cars, airplanes and oil tankers. Collateral trust bonds are simi- debenture?
lar to mortgage bonds except they are backed by securities of any company
through the pledge of stocks and bonds. How do mortgage and collateral
bonds compare?

1-12 Principles of Business Credit

 Figure 1-3 How Bonds Work

Corporate Bonds
Corporations use bonds:
 To raise capital to pay for expansion, modernization
 To cover operating expenses
 To finance corporate takeovers or other changes
in management
Investors willing Bond
U.S. Treasury Bonds
to lend money matures
The U.S. Treasury floats debt issues:
 To pay for a wide range of government programs
 To pay off the national debt

Municipal Bonds
States, cities, countries and town issue bonds:
 To pay for a variety of public projects (schools,
highways, stadiums, sewage systems, bridges)
 To supplement their operating budgets

Investors get paid Investors get interest payments

at maturity at regular intervals

Consumer Credit
Consumer credit is defined as credit extended to a natural person primarily for personal, family or household
purposes. It excludes business and agricultural credit and loans exceeding $54,600 (subject to increase for inflation)
that are not secured by real property or a dwelling. It must also be extended by a creditor. Common forms of con-
sumer credit include credit cards, store cards, auto finance, personal loans (installment loans), consumer lines of
credit, retail loans (retail installment loans) and mortgages.
Consumer credit can be classified as open-end, closed-end or incidental.
Open-end credit is an agreement by a bank to lend a specific amount to a borrower and to allow that amount to
be borrowed again once it has been repaid. Also called revolving credit or revolving line of credit. In open-end credit,
the creditor:

• Reasonably expects the customer to make repeated transactions.

• May impose a finance charge from time to time on the unpaid balance.
• Generally makes the amount of credit available again to the consumer as the outstanding
balance is paid.

Closed-end credit means credit which is to be repaid in full (along with any interest and finance charges) by a
specified future date. Most real estate and auto loans are closed-end.
Incidental credit is extended by service providers, such as a hospital, doctor, lawyer or retailer and allows the
client or customer to defer the payment of a bill. There is no credit card involved. There is no finance charge and no
agreement for payment in installments.

Agricultural Credit Comprehension Check

Define consumer credit.
Agricultural credit encompasses any of several credit vehicles used to
finance agricultural transactions, including loans, notes, bills of exchange and
List and explain three ways
banker’s acceptances. These types of financing are adapted to the specific consumer credit can be
financial needs of agricultural operations, which are determined by planting, classified.
harvesting and marketing cycles. Short-term credit finances operating expenses,

Chapter 1 | Credit in the Business World 1-13

 intermediate-term credit is used for farm machinery and long-term credit is used for real-estate financing. Agricul-
tural credit often presents more risk to the creditor and is sometimes placed into its own unique category.

Business Credit
Business credit refers to extensions of credit primarily for business or commercial purposes. It is often referred
to as business-to-business (B2B) credit. Outstanding trade credit represents nearly 20% of the annual U.S. GDP.
Without business credit, the majority of companies would have a serious liquidity issue.
The important characteristics of business credit are:

• Selling terms are relatively short.

• Transactions are usually on open account or unsecured, but may be partially secured or
secured in full.
• Cash discounts may be offered for payment before the net due date.
• The terms include transactions to manufacturers, wholesalers and retailers, but specifically
exclude the consumer.
• The timeliness in reaching a decision whether or not to extend credit is often much more
critical in the business setting. Delays in the manufacturing process can increase costs and
reduce the quality of perishable goods.

The fact that business credit finances the intermediate and final stages of production and distribution distin-
guishes it from consumer credit. Business credit sales also yield a profit on goods sold rather than interest or invest-
ment income, which distinguishes it from bank and investment credit.
Unsecured, open account credit is the most widely used form of domestic business credit. In open account
credit, the creditor reasonably expects the customer to make repeated transactions and generally makes more credit
available to the buyer as the outstanding balance is paid. A typical business creditor who sells on open account
terms is relying specifically on the full faith and credit of a purchaser. The seller establishes the terms of sale. Open
account terms are also called ordinary terms or standard terms.
A secured credit arrangement is one in which collateral is provided to the creditor. By obtaining some form of
security, the creditor can reduce repayment risk. Examples where secured credit may be useful are a start-up busi-
ness or an undercapitalized business or an opportunity to sell an account that cannot justify a high credit exposure.
Security is obtained not only when the buyer’s financial condition is weak, but in order to guarantee payment if the
buyer’s financial condition changes. While it cannot strengthen a buyer’s financial weakness, a secured credit
arrangement does reduce the likelihood of loss. Secured credit is defined in Article 9 of the Uniform Commercial
Code. It is important to note that drafts, trade acceptances and promissory notes are not forms of security. Each of
these instruments is written evidence of debt. However, no security attaches to the instrument.
The ability to compete in the global marketplace is a necessity resulting in the globalization of credit. The proce-
dure for an export credit decision includes more elements than for a domestic decision. In addition to the traditional
Five Cs of Credit, other elements such as the risks associated
with the economic stability of a country (country risk) must be
Comprehension Check evaluated. The strength and stability of foreign currency versus
Explain what open account credit is. the exporter’s currency play a major role in the success of an
international credit transaction. Also, the buyer’s culture and
What is the difference between unsecured customs may influence the credit transaction. These factors—
and secured credit? country risk, currency issues and culture—add three more
dimensions to the Five Cs of Credit.

Bank Credit
Bank credit differs from business credit in a number of ways, but primarily in terms of the type of resource which
changes hands in a transaction. A bank furnishes money, while a business (supplier, wholesaler, manufacturer or

1-14 Principles of Business Credit

other service provider) furnishes goods or services. After the transaction is completed, both the banker and the
business supplier are creditors: the customer owes money to each entity.

The Federal Reserve and the U.S. Payment System

The Federal Reserve Bank, more commonly known as the Federal Reserve or simply the Fed, is the United States’
central bank, charged with ensuring the stability and flexibility of the nation’s monetary and financial systems.
The Federal Reserve is structured to be independent within the federal government. The Federal Reserve System
is made up of the Board of Governors, the Federal Open Market Committee and 12 regional banks.

Structure
The Board of Governors
The Board of Governors, located in Washington, DC, is the “government agency” part of the Federal Reserve
System; it is the Chairman of the Board of Governors who reports to Congress, and the Board of Governors that sets
the regulations for the entire Federal Reserve System per its Congressional mandate.
There are seven members of the Board—themselves called governors—who are all appointed by the president
of the United States and confirmed by the U.S. Senate. Each governor’s term is limited to 14 years, and the terms of
each governor are staggered so that one governor’s term expires every other year. The Chairman and Vice Chairman
of the Board—required to have been Board members themselves—each serve four-year terms.
Of the four monetary policy tools at the Fed’s disposal (open market operations, the discount rate, reserve
requirements and contractual clearing balances), the Board of Governors has sole control over reserve requirements
and joint control over the discount rate (with the regional banks), but it does not control open market operations.

Figure 1-4 Boundaries of Federal Reserve Districts

The Regional Banks

There are 12 regional banks within the Federal Reserve System. Each bank is run by a bank president and nine
directors, chosen from outside the bank. Three of those directors represent member banks and the rest are from
the public, designed to represent a diverse selection of the region’s population.
The functions of the 12 regional banks include:

Chapter 1 | Credit in the Business World 1-15

 • Operating their portion of the nationwide payment system.
• Distributing currency throughout the region.
• Supervising regional member banks and bank holding companies.
• Serving as bankers for the U.S. treasury.
• Acting as a banker’s bank—a depository institution for the regional banks (responsibilities
include lending money to depository institutions through the discount window).

Each bank is assigned a number and a letter: look on any U.S. currency to see a
number and a letter corresponding to the Federal Reserve Bank that distributed that Comprehension Check
piece of currency. To aid the regional banks in their supervisory and financial service Explain the structure of the
responsibilities, many banks have branches throughout their districts. The following Federal Reserve.
table lists the 12 regional Federal Reserve Banks and their branches.

Figure 1-5 Federal Reserve Banks

Number Letter Bank Branch

1 A Boston
2 B New York
3 C Philadelphia
4 D Cleveland Cincinnati, OH
Pittsburgh, PA
5 E Richmond Baltimore, MD
Charlotte, NC
6 F Atlanta Birmingham, AL
Jacksonville, FL
Miami, FL
Nashville, TN
New Orleans, LA
7 G Chicago Detroit, MI
8 H St. Louis Little Rock, AR
Louisville, KY
Memphis, TN
9 I Minneapolis Helena, MT
10 J Kansas City Denver, CO
Oklahoma City,OK
Omaha, NE
11 K Dallas El Paso, TX
Houston, TX
San Antonio, TX
12 L San Francisco Los Angeles, CA
Portland, OR
Salt Lake City, UT
Seattle, WA

1-16 Principles of Business Credit

The Federal Open Market Committee
The third part of the Federal Reserve System is the Open Market Committee, which is charged with buying
and selling securities on the open market in order to change the supply of money held in deposit at the Federal
Reserve Banks.
The FOMC is made up of all seven governors from the Board of Governors, the president of the Federal Reserve
Bank of New York and four presidents of other regional banks. The four positions for regional Bank presidents rotate
each year.
The FOMC meets eight times a year to discuss current economic conditions in the United States. At that meeting,
the FOMC sets a target federal funds rate which is the interest rate at which depository institutions (banks and
credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. It is a
rate it perceives will affect the supply of and demand for money so as to stimulate the economy in the desired direc-
tion. After the federal funds target rate is set, securities are accordingly bought and sold on the open market by the
Federal Reserve Bank of New York.

Federal Reserve Areas of Responsibility

Since the Fed was established by the Federal Reserve Act in 1913, its roles and responsibilities have evolved. The
Fed has three primary areas of responsibility:

1. To guide monetary policy for economic stability.

2. To regulate and supervise banking institutions in the U.S.
3. To provide financial services to banking institutions, the U.S. government and foreign official
institutions; as well as to play a major role in operating the nation’s payment system.

Monetary Policy
The overall economic goals of the Federal Reserve are maximum employment, stable prices and moderate long-
term interest rates. When reached, those goals indicate that the U.S. economy is strong and stable. The Federal
Reserve uses four possible tools to control, to a certain extent, the amount of money in the economy.

The Discount Rate

The discount rate is the interest rate Federal Reserve Banks charge their member banks for short-term loans.
These loans are conducted through the discount window at each of the regional Federal Reserve Banks. The dis-
count window is often used by banks to satisfy not only their short-term funds needs, but also to fund longer-term
loans (e.g., those needed to cover seasonal fluctuations in customer deposits and withdrawals).
Loans made through the discount window are transacted at the prevailing discount rate. If the Fed lowers the dis-
count rate, for example, it becomes more lucrative than before for banks to borrow money from the Fed, so they do
borrow, putting money into circulation in the economy. If, on the other hand, the Fed wants to decrease the amount
of money in the economy, it can raise the discount rate, making it less lucrative for banks to borrow money from the
Fed, so they borrow less, leaving more cash on deposit at the Fed and less in circulation in the economy.

Chapter 1 | Credit in the Business World 1-17

 Figure 1-6 Effects of a Change in the Discount Rate

Increase in Rate Decrease in Rate

Banks are discouraged from

Banks are encouraged to borrow
borrowing from the
from the Federal Reserve
Federal Reserve

Bank reserves increase Bank reserves decrease

Fewer funds are available for More funds are available for
lending, which causes interest lending, which causes interest
rates to rise rates to fall

Businesses and consumers are Businesses and consumers are

discouraged from borrowing encouraged to borrow

Open Market Operations

Open market operations is the purchase or sale of securities, primarily U.S. Treasury securities, in the open mar-
ket to influence the level of balances that depository institutions hold at the Federal Reserve Banks and the rate at
which banks lend each other money from their Federal Reserve Bank balances (the federal funds rate). Open market
operations are conducted at the Federal Reserve Bank of New York.
Even though banks are lending money from their Federal Reserve deposit accounts, the Fed cannot actually
change the federal funds rate. Instead, the Federal Open Market Committee targets a federal funds rate that it
believes would mean stability and strength for the economy on the whole. Then it engages in open market opera-
tions to try and get the actual federal funds rate close to the target rate.
Open market operations are based on the same principle as the discount rate: changing the supply of money. By
selling government securities, for example, the Federal Reserve decreases the supply of money available to deposi-
tory institutions (because it’s effectively giving security notes in exchange for cash)—and that, in turn, increases the
price of that money—the federal funds rate. Buying government securities, on the other hand, increases the supply
of money available to depository institutions (it’s effectively taking security notes in exchange for cash), which, in
turn, decreases the price of that money—the federal funds rate.

The Reserve Requirement

The reserve requirement is the portion of a member bank’s deposits that it
must hold in reserve in its own vaults or on deposit at its regional Reserve bank. Comprehension Check
By increasing the reserve requirement, it takes money out of the economy. By Briefly explain the concept of
decreasing the requirement, it increases the money supply. In practice, the Fed reserve requirement.
rarely changes the reserve requirement more than once every few years.
What would the effect be if
the Fed raised the reserve
requirement? What if the
requirement was lowered?

1-18 Principles of Business Credit

 Figure 1-7 Effects of a Change in the
Reserve Requirements

Increase in Decrease in
Requirements Requirements

Bank reserves are increased Bank reserves are decreased

Fewer funds are available More funds are available

for lending, which causes for lending, which causes
interest rates to rise interest rates to fall

Businesses and
Businesses and consumers
consumers are discouraged
are encouraged to borrow
from borrowing

Comprehension Check
Contractual Clearing Balances List the four major tools used
Contractual clearing balances is an amount that a depository institution agrees by the Fed to expand or
to hold at its Federal Reserve Bank in addition to any required reserve balance. contract the money supply
and to control interest rates.
Banking Supervision
One of the primary reasons that Congress created the Federal Reserve System in 1913 was to avoid banking
crises like the one in 1907. One way the Fed does that is by backing up banks’ deposits, if need be, through discount
window loans. Another way the Fed works to ensure a stable banking system is through regulation and supervision.
The Board of Governors is responsible for the regulation part, writing the rules that will keep the banking system
stable and competitive. The 12 regional banks, along with the Board, are responsible for supervision, enforcing
those rules.

Safe, Sound and Competitive Banking Practices

Together, the regional Federal Reserve Banks supervise approximately 900 state member banks and 5,000 bank
holding companies. Banks that are not supervised by the Federal Reserve, such as national banks and state banks
that are not members of the Federal Reserve System, are supervised by the Office of the Comptroller of the Cur-
rency or the Federal Deposit Insurance Corporation, respectively.
The supervisory role of the Federal Reserve banks involves annual examinations of each bank’s risk management
and other performance measures. At each examination, the bank is given a performance rating from the Federal
Reserve, which amounts to either a mark of approval or a warning to do better. Banks that do not get the mark of
approval are monitored more closely throughout the year and can be mandated to make certain changes to come
back within the bounds of the regulations.

Protection of Consumers in Financial Transactions

Congress has charged the Federal Reserve with making, interpreting, and Comprehension Check
enforcing laws that protect the rights of consumers, such as discrimination in Must all banks belong to the
lending and inaccurate disclosure of credit costs or interest rates. Federal Reserve System?

Chapter 1 | Credit in the Business World 1-19

 The Federal Reserve Banks also take a large educational role in helping consumers understand the rights they
have in financial transactions, and helping consumers spot signs that those rights are being violated.

Stable financial markets

One of the roles of the Federal Reserve Banks is to provide stability to the financial system and contain systemic
risk that may arise in financial markets.

Financial Services
In addition to guiding monetary policy and supervising and regulating member banks, the Federal Reserve also
provides a number of financial services to member banks and to the federal government. These services include
payment systems policies and solutions as well as currency distribution operations.

The Banker's Bank

The financial services that the Federal Reserve Banks provide their member banks include:

• Maintaining the banks’ deposit accounts with the Federal Reserve.

• Providing payment services, including collecting and processing checks as well as bank-to-
bank electronic fund transfers (EFTs) and automated clearing house (ACH) services.
• Distributing and receiving U.S. currency into and out of the banks’ deposit accounts.

The Government's Bank

The financial services that the Federal Reserve Banks provide the federal government include:

• Acting as fiscal agents.

• Paying treasury checks.
• Processing electronic payments.
• Issuing, transferring and redeeming U.S. government securities.

Research and Information

The Federal Reserve System also conducts research on the U.S. and regional economies and distributes informa-
tion about the economy to the public through published articles, speeches by board members, seminars and
websites. This information is released to the public as part of the Fed’s mandate to study the economy.
Two important outlets for this information are:

• Summary of Commentary on Current Economic Conditions by Federal Reserve District

commonly known as the Beige Book. This report is published eight times per year. Each
Federal Reserve Bank gathers anecdotal information on current economic conditions in its
District through reports from Bank and Branch directors and interviews with key business
contacts, economists, market experts and other sources. The Beige Book summarizes this
information by District and sector. An overall summary of the twelve district reports is
prepared by a designated Federal Reserve Bank on a rotating basis.
• Fed Minutes are notes from discussions the Federal Open Market Committee has over
economic policy. They are released eight times a year, after each meeting. They often detail
discussions between members over what policy to follow.

Comprehension Check
What two publications does
the Fed release to the public
as part of their mandate to
study the economy?

1-20 Principles of Business Credit

Check Processing
The Federal Reserve Banks provide check collection services to depository institutions. When a depository insti-
tution receives deposits of checks drawn on other institutions, it may send the checks for collection to those institu-
tions directly, deliver them to the institutions through a local clearinghouse exchange, or use the check-collection
services of a correspondent institution or a Federal Reserve Bank. For checks collected through the Federal Reserve
Banks, the accounts of the collecting institutions are credited for the value of the checks deposited for collection
and the accounts of the paying banks are debited for the value of checks presented for payment. Most checks are
collected and settled within one business day.
In the 1950s, the Federal Reserve developed and implemented the magnetic ink character recognition (MICR)
system for encoding pertinent data on checks so that the data could be read
electronically. The characters are printed at the bottom of a check in what is Comprehension Check
called the MICR line.
What is the MICR system?
The first section, or the first nine digits, of the MICR line is called the transit
routing number, which provides information about the financial institution on What information does the
which the check is drawn. Additional sections of the MICR line identify the: pay- MICR line contain?
or’s account number, sequence number and encoded amount. (See Figure 1-8)

Figure 1-8 Sample Check

John Smith 1068

10 Unknown Drive
Somewhere, RI 12345 May 1, 2012
PAY TO THE
ORDER OF
Chris Jones $121.13
One hundred and twenty-one and 13/100 DOLLARS

FOR

: 07 49 0227 3 : 27 4650 6 1068 0000012113

Routing Payor account Sequence Encoded check

number number number amount

In 1987, Congress enacted the Expedited Funds Availability Act (EFAA), which limits the time that banks can
hold funds from checks deposited into customer accounts before the funds are made available for withdrawal. The
law, implemented in September 1988 through the Board of Governors’ Regulation CC, Availability of Funds and Col-
lection of Checks, also establishes rules designed to speed the return of unpaid checks.
The Federal Reserve has an availability schedule that details the time it takes to make funds available. The delay
between the time a check is deposited at the bank and the time the depositor’s account is credited with collected
funds by the bank is called availability float.

Chapter 1 | Credit in the Business World 1-21

 Figure 1-9 Availability Float

Check encoded and processed Depositer receives

Check is deposited
through clearing system collected funds

Availability float was affected by the Check Clearing for the 21st Century Act (Check 21), which became effective
October 28, 2004. The purpose of Check 21 is to remove barriers to the electronic collection of checks allowing banks
to “truncate checks.” Check truncation is the process of taking the physical paper check out of circulation, capturing
the check information electronically, and moving the electronic copy through the clearing system. The paper check
is destroyed or put into secured storage.
There are some practical effects of Check 21 that credit managers must take into account. When a customer
claims payment was made, the credit manager must accept the substitute check as proper evidence of payment.
According to the Act, courts, retailers and services providers are all required to accept the substitute check as proof
of payment in the same manner as they would accept the original. From a credit manager’s standpoint, the faster
clearing process has two significant benefits:

1. Funds will end up in the creditor’s accounts faster thus increasing

Comprehension Check
their cash balances.
Define the term
2. Checks drawn on an account with insufficient funds will be known
availability float.
sooner.
Define check truncation.

Electronic Funds Transfer

Electronic funds transfer (EFT) is the electronic transfer of money from one bank account to another, either
within a single financial institution or across multiple institutions, through computer-based systems and without the
direct intervention of bank staff. There are several types of services for electronically transferring payments.
Automated Clearing House (ACH) is an electronic network for financial transactions in the United States. ACH
processes large volumes of credit and debit transactions in batches. The Federal Reserve Banks (FedACH) and Elec-
tronic Payments Network (EPN) are the two national ACH operators.
Fedwire is a real-time method of transferring cash value from one bank to another, using Federal Reserve account
balances.
SWIFT (Society for Worldwide Interbank Financial Telecommunication) is a dedicated computer network to sup-
port funds transfer messages internationally between member banks worldwide.
CHIPS (Clearing House Interbank Payments System) is a worldwide bank-owned, private-sector U.S.-dollar funds-
transfer system for cross-border and domestic payments.
TARGET2 is the real-time gross settlement (RTGS) system owned and operated by the Eurosystem. TARGET
stands for Trans-European Automated Real-time Gross settlement Express Transfer system. TARGET2 is the second
generation of TARGET.
TIPANET (Transferts Interbancaires de Paiement Automatisés) is an international payment system set up by the
European cooperative banks.

Comprehension Check
Define the term electronic funds
transfer.

List the types of services for

electronically transferring funds.

1-22 Principles of Business Credit

Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC) was created in 1913 as an independent agency to preserve and
promote public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least
$250,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect
on the economy and the financial system when a bank or thrift institution fails. The FDIC insures approximately $9
trillion (as of 2016) of deposits in U.S. banks and thrifts—deposits in virtually every bank and thrift in the country.
The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership cate-
gory. The FDIC insures deposits only. It does not insure securities, mutual funds or similar types of investments that
banks and thrift institutions may offer.
The FDIC directly examines and supervises more than 4,500 banks and savings banks for operational safety and
soundness, more than half of the institutions in the banking system. Banks can be chartered by the states or by the
federal government. Banks chartered by states also have the choice of whether to join the Federal Reserve System.
The FDIC is the primary federal regulator of banks that are chartered by the states that do not join the Federal
Reserve System. In addition, the FDIC is the back-up supervisor for the remaining insured banks and thrift institutions.
The FDIC also examines banks for compliance with consumer protection laws, including the Fair Credit Billing
Act, the Fair Credit Reporting Act, the Truth-In-Lending Act, and the Fair Debt Collection Practices Act, to name a
few. Finally, the FDIC examines banks for compliance with the Community Reinvestment Act (CRA) which requires
banks to help meet the credit needs of the communities they were chartered to serve.
The FDIC is managed by a five-person Board of Directors, all of whom are
appointed by the president and confirmed by the Senate, with no more than Comprehension Check
three being from the same political party. It is headquartered in Washington, DC,
What does the FDIC
but conducts much of its business in six regional offices, and in field offices not insure?
around the country.

Online Business Banking

For credit professionals, the advent of online business banking has simplified money management. Enrolling in
online business banking makes it easier to monitor accounts, financials, account history and statements; transfer
funds between accounts and banks; pay bills and more.
With online business banking and remote deposit capture, it is not necessary to carry checks to the bank. They
can be scanned in the office and deposited via a secure internet connection. Images of posted checks are available
when necessary.
Online banking also allows for the assignment of different security levels for multiple users. In addition to secure
deposits, all other transactions online are usually protected by a firewall and encryption technology to ensure the
security of business information and financial data.
Other advantages include: automatic payments and debits, transaction alerts, cost savings and direct deposit,
among others.
For businesses trading worldwide, there are international banks which provide access to bankers working in
other countries. They can provide currency risk management and also help with foreign exchange, importing and
exporting, wire transfers and inter-country payments.

Comprehension Check
What are some of the
advantages of online
business banking?

Chapter 1 | Credit in the Business World 1-23

Key Terms and Concepts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Agricultural credit, 1-13–1-14 Federal Deposit Insurance Corp. (FDIC), 1-23
Asset-backed bonds, 1-12 Federal funds rate, 1-18
Automated Clearing House (ACH), 1-22 Federal Open Market Committee, 1-17
Availability float, 1-21–1-22 Federal Reserve System (The Fed), 1-15–1-20
Bank credit, 1-14–1-15 Fed Minutes, 1-20
Beige Book, 1-20 Fedwire, 1-22
Board of Governors, 1-15, 1-19 Financial services, 1-17, 1-20
Bonds, 1-12–1-13 Five Cs of Credit, 1-6–1-8, 1-14
Business credit, 1-14 Fixed-income securities, 1-12
Buyers, 1-9 Funds transfer, 1-22
Canons of Business Credit Ethics, 1-8–1-9 Incidental credit, 1-13
Capacity, 1-7 Investment credit, 1-12–1-13
Capital, 1-7 Magnetic Ink Character Recognition (MICR)
Character, 1-6–1-7 system, 1-21
Check 21, 1-22 Mortgage bonds, 1-12
Check truncation, 1-22 Municipal bonds, 1-13
Clearing House Interbank Payments National Association of Credit Management
System (CHIPS), 1-22 (NACM), 1-3–1-4
Closed-end credit, 1-13 Online business banking, 1-23
Collateral, 1-7–1-8 Open account credit, 1-14
Collateral trust bonds, 1-12 Open-end credit, 1-13
Collection stage, 1-10 Open market operations, 1-18
Conditions, 1-8 Operating cycle, 1-10
Consumer credit, 1-13 Private credit, 1-11, 1-12–1-15
Contractual clearing balance, 1-19 Production stage, 1-10
Corporate bonds, 1-12, 1-13 Public credit, 1-11
Country risk, 1-14 Regional banks, 1-15–1-16
Credere, 1-5 Reserve requirement, 1-18–1-19
Credit, 1-5–1-6 Secured bonds, 1-12
Creditworthiness, 1-10 Secured credit arrangement, 1-14
Culture, 1-14 Structure, Federal Reserve, 1-15–1-17
Currency issues, 1-14 SWIFT, 1-22
Debentures, 1-12 TARGET2, 1-22
Discount rate, 1-17–1-18 TIPANET, 1-22
Electronic funds transfer (EFT), 1-22 Unsecured, open account credit, 1-14
Equipment trust certificates (ETC), 1-12 U.S. Treasury Bonds, 1-13
Expedited Funds Availability Act (EFAA), 1-21

1-24 Principles of Business Credit

Comprehension Check. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. The idea of exchanging goods or services on credit developed after centuries of trade.
Explain some of the reasons why credit evolved.
2. Explain why organizations like NACM evolved.
3. List and explain the reasons credit terms are offered.
4. Explain why a sale may not occur, in the business setting, if credit is not offered.
5. What does the Latin term credere mean? How does it describe the credit process?
6. Explain why selling on credit is more costly than selling for cash, but ultimately
beneficial. Give three reasons.
7. List and explain the important elements of credit.
8. List and explain the Five Cs of Credit. What are some additional Cs of Credit? Describe
why one is considered more important than the others.
9. Define the term operating cycle.
10. Why will a manufacturer be both a debtor and a creditor at any given time?
11. Define and give an example of public credit.
12. Define and list the major types of private credit.
13. What is the most common type of corporate bond? List the characteristics of this type
of bond.
14. What is the difference between a secured bond and a debenture?
15. How do mortgage and collateral bonds compare?
16. Define the term consumer credit.
17. List and explain three ways consumer credit can be classified.
18. Define and explain the important characteristics of business credit.
19. Explain what open account credit is.
20. What is the difference between unsecured and secured credit?
21. Explain the structure of the Federal Reserve.
22. Define the term discount rate.
23. Briefly explain the concept of reserve requirement.
24. What would the effect be if the Fed raised the reserve requirement? What if the
requirement was lowered?
25. List the four major tools used by the Fed to expand or contract the money supply and
to control interest rates. Explain the relationship between the tools and their influence
on the money supply.
26. Must all banks belong to the Federal Reserve System?
27 What two publications does the Fed release to the public as part of their mandate to
study the economy?
28. What is the MICR system?
29. What information does the MICR line contain?
30. Define the term availability float.
31. Define check truncation.
32. Define the term electronic funds transfer.
33. List the types of services for electronically transferring funds.
34. What does the FDIC not insure?
35. What are some of the advantages of online business banking?

Chapter 1 | Credit in the Business World 1-25

Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
• Credit has been documented to have been used as early as 1300 B.C. by the Babylonians
and Assyrians. Credit also played a fundamental role in financing the United States during
the American Revolution.
• Institutions like Dun & Bradstreet and NACM arose because of a clear need for information
and resources, which include, but are not limited to the following:
– Honest and fair dealings in credit transactions
– Ensuring good laws for sound credit
– Fostering and facilitating the exchange of information
– Promoting and expediting information for international trade
– Training credit professionals
• The seven reasons to offer credit are:
– To increases sales
– Competition
– Promotion
– Credit availability
– Convenience
– Demand
– Price
• Credit involves trust and is ultimately more costly than dealing in cash, although the
benefits can outweigh the costs.
• The six elements of credit are:
– Risk of nonpayment
– Timing
– Security
– Extra costs
– Legal aspects
– Economic influences
• The Five Cs of Credit are character, capacity, capital, collateral and conditions, but one
might want to also consider competition and common sense as additional Cs.
• The two types of credit are public and private. Public involves the government, while
private extends to businesses and individuals.
• The five types of private credit are:
– Investment credit
– Consumer credit
– Agricultural credit
– Business credit
– Bank credit
• The Federal Reserve is composed of the Board of Governors, the Federal Open Market
Committee and the 12 regional banks.
• The Federal Reserve has four main tools that control the money supply and the monetary
policy of the U.S., which ultimately controls and manipulates various interest rates. They
include: open market operations, the discount rate, reserve requirements and contractual
clearing balances.

1-26 Principles of Business Credit

 • Besides controlling monetary policy and interest rates, the Federal Reserve also ensures
safe, sound and competitive banking practices, consumer protection, stable financial
markets, financial services and published economic research.
• The FDIC insures approximately $9 trillion (as of 2016), which correlates to $250,000 per
depositor, per insured bank.
• Online business banking has simplified money management making it easier to monitor
accounts, financials, account history and statements, as well as facilitating the transfer of
funds between accounts and bank assisting domestic and international business.

References and Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Board of Governors of the Federal Reserve System. The Federal Reserve System: Purposes and Functions, 2013.
"Credit Risk Review." NACM Graduate School of Credit and Financial Management project, 2016. Kathie Knudson, CCE;
Lisa Ball, CCE; Stacy Parker, CCE; and Dawn Dickert, CCE.
Emery, Gary W. Corporate Finance: Principles and Practices. New York: Addison Wesley, 1998.
Gallinger, George W. and Jerry B. Poe. Essentials of Finance: The Integrated Approach. New Jersey: Prentice
Hall, 1995.
Hill, Ned. C. and William L. Satoris. Short-Term Financial Management: Text and Cases. New Jersey: Prentice
Hall, 1995.

Chapter 1 | Credit in the Business World 1-27