Chapter 1

Part A: Foundations of credit

Introduction to credit management

Last updated November 20268 sectionsabout 9 min read

Key takeaways

Credit is an arrangement in which a creditor supplies money, goods or services to a debtor now, against a promise of payment later, usually with interest or a charge for the time value of money and the risk taken.
The credit cycle runs through seven stages in order: application, assessment, approval or decline, disbursement or supply, monitoring, collection and closure.
Credit reaches customers through three channels: consumer credit to individuals, trade credit between businesses, and export credit across international borders.
Credit is not free to the creditor: it ties up working capital and costs money to assess, administer and collect.
Overdue accounts hurt profit through bad debts and provisioning, and hurt liquidity and cash flow because money owed cannot pay the business's own suppliers, wages or loan instalments.

Credit is one of the oldest tools of commerce, and the modern credit function, whether inside a bank, a SACCO, a manufacturer's sales ledger, or an exporter's finance team, still does the same three things: decide who to trust with goods or money today against a promise to pay later, keep track of that promise, and collect on it. This chapter sets out where the profession came from and the vocabulary the rest of the paper builds on.

History of credit management

Ancient origins

Credit predates money itself: early Mesopotamian and Egyptian records show grain and livestock advanced against a future harvest, and Babylon's Code of Hammurabi (c. 1750 BC) already regulated interest and debt.

The Greek experience

Ancient Greek trade extended credit between merchants across city-states and, through maritime loans that funded a voyage against repayment (plus a premium) only if the ship returned safely, an early form of risk-priced lending.

The Reformation

Medieval Christian doctrine treated charging interest (usury) as sinful, which restricted formal lending. The Reformation's more permissive view of interest, alongside the growth of European trade, helped commercial credit and banking develop into recognisably modern forms from the 16th century onward.

A modern philosophy of credit

Today credit is treated as a legitimate, professionally managed function: not simply 'trust', but a disciplined process of assessing risk, setting terms, and monitoring performance, run by a dedicated credit department (see the chapter on the credit department) using structured analysis (see the chapter on credit assessment).

Definition of credit

Credit is an arrangement in which one party (the creditor) supplies money, goods, or services to another party (the debtor) now, in exchange for a promise of repayment or payment at a later date, usually with interest or a charge added to compensate the creditor for the time value of money and the risk taken.

The credit cycle

The credit cycle is the sequence a credit facility passes through from first contact to final closure.

Stages of the credit cycle
Application: the customer requests credit and supplies information about themselves and their needs
Assessment: the creditor analyses the application using credit analysis techniques (see the chapter on credit assessment)
Approval/decline: a credit decision is made, and terms (limit, tenure, price, security) are set
Disbursement/supply: funds are released or goods/services are supplied on credit
Monitoring: the account is tracked for conduct against the agreed terms
Collection: amounts falling due are collected (see the chapter on debt collection), including any recovery action needed
Closure: the facility is repaid in full and the account is closed, or written off if irrecoverable

Why businesses extend credit

To win and retain customers who cannot or prefer not to pay cash immediately, growing sales volume
To stay competitive where rival suppliers already offer credit terms
To build long-term relationships and customer loyalty
To move stock faster and support production planning, in the case of trade credit between businesses
To earn interest or fee income directly, in the case of a financial institution's core lending business
To support economic activity the business depends on, such as an exporter financing a foreign buyer to secure a sale (see the chapter on export credit)

Types of credit

Consumer credit

Credit extended to individuals for personal, household or consumption purposes, covered in full in the chapter on consumer credit.

Trade credit

Credit extended between businesses in the course of trade, typically supplier to buyer, covered in full in the chapter on trade credit.

Export credit

Credit extended in connection with the sale of goods or services across international borders, covered in full in the chapter on export credit.

Financial effects of credit

Cost of credit

Extending credit is not free to the creditor: it ties up working capital that could otherwise be invested or used elsewhere, and carries the direct cost of assessing, administering and collecting the facility.

Overdue accounts and profit

An overdue account that is never collected becomes a bad debt, a direct charge against profit; even one that is eventually collected late has already cost the business through the provisioning it required in the meantime (see provisioning in the chapter on debt collection).

Overdue accounts and liquidity

Money owed but not yet received cannot be used to pay the business's own suppliers, wages or loan instalments, so a build-up of overdue debtors is a direct threat to a business's ability to meet its own obligations as they fall due.

Overdue accounts and cash flow

Extending credit converts a cash sale into a receivable, delaying the cash inflow; the longer accounts run overdue beyond agreed terms, the more a business's actual cash flow diverges from its reported sales, which is why cash flow, not just profit, is watched closely wherever credit is a large part of the business.

Merits and demerits of credit

Merits	Demerits
Increases sales volume and market share	Ties up working capital that could be used elsewhere
Builds customer loyalty and repeat business	Carries the risk of late payment or default
Enables customers to acquire goods or services beyond their immediate cash resources	Costs money to administer: assessment, monitoring and collection
Smooths a customer's own cash flow, spreading a large cost over time	Can encourage over-borrowing and financial difficulty for the debtor
Supports overall economic growth by enabling transactions that cash alone could not fund	Exposes the creditor to bad debts, which are a direct charge against profit

Credit in the economy

Facilitates trade and commerce by allowing transactions to happen ahead of the buyer having cash in hand
Enables businesses to invest in stock, equipment and expansion beyond their own retained earnings
Supports household consumption and asset acquisition (housing, vehicles, education)
Channels savings productively: institutions that mobilise deposits (banks, SACCOs) lend them out as credit, putting idle funds to work
Underpins international trade, since very little cross-border commerce happens on a strict cash-only basis
Acts as a transmission channel for monetary policy: the price and availability of credit in the economy responds to the central bank's policy rate

Exam tip

This chapter is the paper's glossary: examiners lean on the definition of credit and the stages of the credit cycle as the shared vocabulary for questions in every later chapter, so a shaky grip here costs marks well beyond this chapter itself.

Self-check

(a) A customer submits a loan application, which is analysed, approved, disbursed, monitored, and eventually repaid in full. Identify the seven stages of the credit cycle this passes through, in order. (7 marks)

(b) State the definition of credit. (3 marks)

(d) Explain why overdue accounts threaten a business's liquidity even before any bad debt is actually written off. (3 marks)

Show worked answer

(a) Application; assessment; approval/decline; disbursement/supply; monitoring; collection; closure (7 marks).

(b) An arrangement in which one party (the creditor) supplies money, goods, or services to another party (the debtor) now, in exchange for a promise of repayment or payment at a later date, usually with interest or a charge added (3 marks).

(c) Any two of: to win and retain customers who cannot or prefer not to pay cash immediately; to stay competitive where rivals already offer credit; to build long-term relationships and loyalty; to move stock faster; to earn interest or fee income directly (2 marks).

(d) Money owed but not yet received cannot be used to pay the business's own suppliers, wages or loan instalments, so a build-up of overdue debtors is a direct threat to the business's ability to meet its own obligations as they fall due, this liquidity risk exists whether or not the debt is ever ultimately written off as a bad debt (3 marks).