Posted in Finance, Accounting and Economics Terms, Total Reads: 800
Definition: Cost of Credit
The operation of most banks and financial institutions consist of borrowing and lending money. For lending money, these institutions charge a particular interest rate from the borrowers. Similarly for borrowing, they also have to pay the lenders amounts at fixed rates. This rate at which their creditors will require money for lending the funds required for their operation is called the ‘cost of credit’ for that particular organisation.
The amount of profit earned by the organisation hugely depends on the spread between the interest rate it charges and its own cost of credit, the former being obviously greater. Not only banks, the concept applies to all corporates who borrow funds for their operation. The credit cost appears as a liability on the balance sheet and as interest expense on the income statement.
A very important use of this concept is in determining the suitability of early payment between organisational (B2B) transactions. Seller organisations often offer discounts on early payments made by the purchasing party. The accounts department of the seller will deem such a transaction as viable only when the cost of credit due to the discount exceeds the seller’s own cost of credit.