What is Trade Credit?
Trade credit is money that a business owes to its suppliers for goods that it has purchased. It’s like borrowing money from your friend and agreeing to pay them back later. The three important things to know about trade credit are: how much money you borrowed (which is the amount of the purchase invoice), how long you have to pay it back (which is the credit period), and if you pay it back on time, you won’t have to pay any extra money (which means the interest rate is practically zero).
Trade debt / trade credit is also known as a planned source of working capital. The amount and period of credit are dependent on two things. First, 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.
- What is Trade Credit?
- Terms of Trade Credit Policy
- Why is it Important to Manage Trade Credit?
- Techniques to Manage Trade Credit
- Frequently Asked Questions (FAQs)
Terms of Trade Credit Policy
Trade credit terms are also known as terms of payment or terms of credit policy. Whatever the names are, the terms should be followed judiciously by both (creditors and debtors) to enjoy smooth workings and long-term relations. Debtors should release payment within the period specified, and creditors should encourage the debtors to abide by the agreed terms. The three main terms are:
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, the nature of the business, the customer’s credit history and credit rating, etc.
The credit cannot be allowed for an infinite time. 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 number 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 or 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 begins. 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.
Why is it Important to Manage Trade Credit?
Managing trade credit is crucial for a business from various angles. Let us look in detail at the various reasons why it is important to manage it.
Source of Working Capital Finance
First of all, trade credit satisfies the working capital financing needs of the business. It is a vital source of working capital finance widely used by businesses. Working capital, in turn, is directly linked with the cash flows of the business. Therefore, proper management of trade credit helps in determining the optimal level of working capital.
Impact on Profitability
Efficient management of trade credit can lead to cost savings. By negotiating favorable payment terms, such as extended credit periods or early payment discounts, a business can reduce its financing costs and improve profitability. Additionally, by closely monitoring credit terms and avoiding late payments or penalties, a business can avoid unnecessary expenses and maintain its financial health.
Managing trade credit helps build and maintain strong relationships with suppliers. By being reliable and prompt in making payments, a business can establish trust and credibility with its suppliers. This can lead to better terms, discounts, or preferential treatment, such as priority access to goods, improved pricing, or extended credit periods.
Techniques to Manage Trade Credit
Now, that we understand why it is important to manage trade credit, let’s dig deep to learn how to manage it effectively. The following are the techniques that a manager employs for managing trade credit.
Negotiate Prices, Cash Discounts, and Credit Period
It is pretty obvious that lower prices, higher discounts, and a longer credit period are the best intersection for any business to opt for a vendor. With lower prices and higher cash discounts, the better and more competitive will be the prices. A longer credit period will reduce the financial overhead of the company.
Calculate and Analyze the Cost of Trade Credit
After the purchase manager negotiates for the best deal, their job isn’t done. They also have to figure out how much it will cost the business to use the trade credit and compare it to other ways of getting money, like loans from the bank. If the trade credit ends up being more expensive than a bank loan, it could hurt the business’s profits and how successful they are.
Strengthen Supplier Relationships
This function of the trade credit manager looks a little contradictory in comparison to others, but it is of utmost importance. It is an accepted fact that one business is dependent on another business. The buyer of raw materials and other components is also dependent on the supplier. While managing and negotiating with suppliers, the manager should not try to take unreasonable benefits out of them. That will hamper the relationships, negatively impacting the supply chain and, hence, sustainable development.
Better Credit Terms
The company should negotiate longer credit periods with its vendors but not at the cost of interest or any other charges. If a company is able to negotiate a credit period from vendors that is longer than the credit period it offers to its customers, it can significantly reduce the working capital requirements.
The company should build software that sends reminders to make the payment at the end of the credit period. The reminders should begin well in advance, say for example 7 days so that it becomes easy to forecast requirements and plan cash flow for the payment.
Along with reminders, a company can also automate its payments with the help of integrating the accounting systems with bank accounts in such a way that it does not miss its payments.
As we have already seen that trade credit is the deferment of payment to accounts payable for a purchase made today, a business should look for the advantages of trade credit as well as the disadvantages of trade credit too. It needs to understand how it can manage trade credit and also why it is required to manage trade credit. All these learnings will help in saving on the financial cost of the business.
Frequently Asked Questions (FAQs)
Yes, trade credit can impact a company’s credit score. Timely payments can help establish a positive credit history and improve the creditworthiness of the buyer. On the other hand, late or missed payments can have a negative impact on the credit score.
Effective management of trade credit involves setting appropriate credit limits, establishing clear payment terms, conducting credit checks on buyers, monitoring credit accounts, implementing collection strategies for late payments, and maintaining open communication between buyers and sellers.
Yes, trade credit terms can be negotiated between buyers and sellers. Buyers may seek longer credit periods or more favorable payment terms, while sellers may consider offering discounts for early payment or adjusting credit limits based on the buyer’s creditworthiness.
No, trade credit and a line of credit are different. Trade credit is specific to a buyer-supplier relationship and relates to purchases made from a particular supplier, while a line of credit is a pre-approved borrowing limit provided by a financial institution that allows businesses to access funds as needed.