Table of Contents
- 1 DEFINITION OF TRADE CREDIT
- 2 TERMS OF PAYMENT / TRADE CREDIT POLICY
- 3 DISADVANTAGES OF TRADE CREDIT
- 3.1 Opportunity Loss of Discount
- 3.2 Increase in Input Prices
- 3.3 Loss of Goodwill
- 3.4 The cost of Administration and Accounting
- 3.5 Loss of Suppliers
- 3.6 Bad Debts
- 3.7 Cash Flow Mismatch as There is No Guarantee of Timely Payment
- 3.8 The cost of Funds Invested in Book Debts / Accounts Payable
- 3.9 The cost of Cash Discount
- 3.10 Running Special Departments
DEFINITION OF TRADE CREDIT
Trade credit is an important Sources of Working Capital extended or generated by the business itself. It can be defined as ‘delay of payment’ permitted by the creditor or supplier of raw materials, consumables etc against the goods purchased from him. Any finance has three important parameters – amount of loan, rate of interest and time period of a loan. In this case, the amount of credit is the bill amount, the rate of interest is practically nil, and the period of credit is the credit period given in the terms of payment.Trade credit is also known as a spontaneous source of finance. It is a major source of working capital finance for most business whether small or big. Amount and period of trade credit are dependent on two things. One, the customs and competition in the particular industry and second, the credibility of the buyer in terms of the liquidity position, profit making ability, past payment records etc.
TERMS OF PAYMENT / TRADE CREDIT POLICY
Terms of trade credit also known as terms of payment or trade credit policy. Whatever name they are called with, but the terms should be followed judiciously by both (creditors and buyers) to enjoy smooth workings and long term relations. Buyers should release payment within the period specified and creditors should encourage the buyer to abide by the agreed terms.
There are three main terms of trade credit viz
Maximum Credit Limit
It is the maximum amount of credit which a customer is allowed. Suppose, $5,000 is the limit and if the buyer has got one bill of $3,000, he will not be allowed another bill of more than $2,000 without clearing dues in the previous bill. The limit is determined by the creditor based on the credibility of the customer, volume of its transactions, past payment track records, nature of business etc.
The credit cannot be allowed for an infinite time period. It is the maximum period of time before which a buyer is expected to make payment. Beyond this period, the creditor may ask for interest on the amount at the rate mentioned in the terms of payment. The no. of days of credit is also determined in the similar fashion like the limit of credit amount.
It is the percentage of discount allowed by the creditor to the buyer to encourage him to pay as early as possible. It is specified like ‘5%/10 net 30’. This means 1% discount is allowed till 10 days i.e. on a bill of $100, the buyer can pay $95 if pays within 10 days. He can pay a net amount of $100 till the 30th day. If the payment is made after 30 days, the creditor will charge interest on agreed rate.
The starting date is the date from which the credit period is started. It can be the billing date, dispatch date, goods received date or any other agreed date. If a buyer is given 45 days of credit, the days will be counted beginning from the starting date.
Advantages and disadvantages of trade credit are important points of consideration before forming any decision relating to trade credit. The key advantage of trade credit is that it is simple to obtain and considered practically cheaper.
On the other hand, it is believed that no supplier will sell products at a loss and therefore against the credit, the creditor bills the buyer at increased prices. Sometimes delaying payment becomes the policy of the buyer to enjoy the credit but it hampers the goodwill of the buyer in the market. There are costs of administering the payment to the creditor on time attached to this type of credit.
DISADVANTAGES OF TRADE CREDIT
Disadvantages of utilizing trade credit include loss of goodwill, higher prices of raw materials, the opportunity cost of discount, administration cost, and under worst circumstances one may lose the supplier as well. For suppliers, bad debts are the biggest disadvantage among others.
Opportunity Loss of Discount
All suppliers provide a discount on bills amount if early payment is made or is made in cash. If the buyer enjoys trade credit, he has to forego the discount otherwise available.
Increase in Input Prices
As very clearly explained above in the advantages of suppliers, the buyers with liberal credit terms are charged with premium prices. This increases the cost of raw materials for the buyer making it a direct increase in the costing of finished goods of the buyer. Finished goods with higher prices are difficult to sustain in the competitive market. We know that price is an important factor for a demand of products. Higher prices may badly impact the demand for the buyer’s products.
Loss of Goodwill
Some managers have a tendency to delay payments till the last point possible. But, they are unaware of the problems posed by their suppliers in the absence of timely payment. Over a period of time, this idea impacts the goodwill of the firm in the market. All the suppliers will come to know about payment delays of the buying firm and will definitely entertain other buyers first. The firm may face problems like late supplies, no supplies in emergencies etc.
The cost of Administration and Accounting
If goods are purchased on credit and the supplier’s list is too long, the cost of maintaining and keeping track on defaults of payment will be high. Business would need a special department just to take care of related issues.
Loss of Suppliers
At times, failure to abide by the terms of credit can cause loss of supplier as well. The supplier may find it difficult to work with the buyers not paying on time as suppliers also have their supplier’s obligation to pay on time.
The biggest risk of trade credit assumed by the suppliers is that of the bad debts. Bad debts are the biggest losses of any business and can take away the whole of the profits of the company. A supplier should always stick to its terms of credit and should not try to extend unreasonable terms to any buyers.
Cash Flow Mismatch as There is No Guarantee of Timely Payment
When a supplier provides credit to the buyer, the ball goes to the buyer’s court. The supplier is completely dependent on the buyer’s willingness to pay. In case the buyer delays the payment, the supplier may face cash flow mismatch problems.
The cost of Funds Invested in Book Debts / Accounts Payable
All suppliers invest their working capital into their debtors/ book debts/ accounts payable. The working capital extended by the bank is not free of cost.
The cost of Cash Discount
As part of encouragement to buyers for early payment, suppliers offer a discount for early payment. This reduces their margins on the sales.
Running Special Departments
Expenses for running special departments to manage trade credit say sales, collection, legal etc are a cost to the supplier which would otherwise not take place.
We conclude that there is a cost of trade credit and it should be quantified and to our surprise, it can be quantified also.