Definition of Trade Credit
Trade credit is an important Source 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 – the loan amount, rate of interest, and time period of a loan. In this case, the amount of credit is the bill amount, the interest rate is practically nil, and the period of credit is the credit period given in terms of payment.
Trade debt/trade credit is also known as a spontaneous source of finance. It is a major source of working capital finance for most businesses, whether small or big. Amount and period of trade credit are dependent on two things. The customs and competition in the particular industry, and second, the buyer’s credibility in terms of the liquidity position, profit-making ability, past payment records, etc.
- Definition of Trade Credit
- Terms of Payment/Trade Credit Policy
- Disadvantages of Trade Credit
- For Buyers
- For Suppliers
Terms of Payment/Trade Credit Policy
Trade credit terms are also known as terms of payment or trade credit policy. Whatever name they are called, 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 that 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 creditor determines the limit based on the credibility of the customer, the 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 terms of payment. The no. of days of credit is also determined similarly to 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 as ‘5%/10 net 30’. This means a 5% discount is allowed for 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 the 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.
The 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 the 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 payment is made early or is made in cash. If the buyer enjoys trade credit, he must forego the otherwise available discount.
Increase in Input Prices
As clearly explained above, in the advantages of suppliers, the buyers with liberal credit terms are charged premium prices. This increases the cost of raw materials for the buyer, making it a direct increase in the cost of finished goods for the buyer. Finished goods with higher prices are difficult to sustain in the competitive market. We know that price is an important factor in the demand for products. Higher prices may badly impact the demand for the buyer’s products.
Loss of Goodwill
Some managers tend 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 firm’s goodwill in the market. All the suppliers will come to know about payment delays of the buying firm and will entertain other buyers first. The firm may face problems like late supplies, no supplies in emergencies, etc.
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 of defaults of payment will be high. Businesses would need a special department 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 challenging to work with the buyers not paying on time as suppliers also have their obligation to pay on time.
The suppliers’ biggest risk of trade credit is that of bad debts. Bad debts are the biggest losses of any business and can take away the whole company’s profits. A supplier should always stick to its credit terms 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. If 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.
Cost of a Cash Discount
As part of encouragement to buyers for early payment, suppliers offer a discount for early payment. This reduces their margins on 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 also be quantified.