Meaning and Definition of Trade Debt
Trade Debt is defined as the money payable by a Company to its supplier for goods or services received by it. In other words, it is an arrangement where payment for goods or services is not made upfront. This payment has to be made to the supplier at a later scheduled date, as decided by both the parties to the deal. This time period for payment is usually 10 days to 90 days. For example, suppose Company A buys goods worth $10000 from Company B. It makes an upfront payment of $2000 at the time of purchase. By mutual agreement, it decides to pay the balance amount of $8000 after a period of 30 days. Here, $8000 is the Trade debt for Company A.
Trade Debt is an Account Payable for the buyer company. For accounting purposes, it is mentioned under the head Current Liabilities. As per the above example, $8000 will be shown under the head Current Liabilities of the Balance Sheet of Company A.
- Meaning and Definition of Trade Debt
- Need and Importance
- Accounting of Trade Debt
- Accounting Entry for the Seller Company
- Advantages of Trade Debt
- Disadvantages of Trade Debt
Need and Importance
In the modern world of business, Trade Credit is absolutely essential for Companies to increase their sales and maintain and expand their customer base. Suppliers sell their goods and services for credit rather than an immediate payment. It is a form of 0% financing for the buyer company, hence enabling it to buy the goods without having the money to pay for them. Trade Debt is an effective tool to increase sales revenue as Companies don’t have to worry about arranging for payment for the goods beforehand every time they need them.
Companies get an opportunity to make the payment after selling the goods. Big Companies can even negotiate and extend the repayment period, depending upon the goodwill they enjoy in the market. Behemoths like Ikea and Walmart work on the same model. Because of their high volume of purchases, they are often able to get very good terms for Trade Debt repayment. After selling off their stocks, they pay to their suppliers. Hence they can maintain excellent cash flows.
Suppliers tend to lose out on immediate payment in cases of trade debt. In many cases, they offer Cash Discounts for Cash or immediate payment at the time of sale. They can also declare a discount percentage for payment made within a stipulated time period. For example, a company may offer a 3% discount if the payment is made within 15 days of the sale. This encourages the buyer to make an early payment, and the seller benefits from the timely payment of dues.
Accounting of Trade Debt
Expenses entry is recorded at the time of the transaction. Cash can exchange hands later. This is the Accrual Basis of Accounting. Hence, entries for Trade Debt are done at the time of the transaction itself.
At the time of the transaction, goods or services purchased are debited, and Trade Debt in the form of Accounts Payable is credited. All such transactions where payment is due will be categorized under the head Accounts Payable. It will be treated as Current Liabilities in the Balance Sheet of the Buyer Company.
At the time of payment of Trade Debt, Accounts Payable will be debited, and Cash/ Bank will be credited. This will decrease the liability balance for the Company, and the Cash/ Bank balance will also decrease accordingly. Accounts Payable balance under the head Current Liabilities will hence decrease. It means that an outstanding liability for the business has been paid off.
For example, in the case of the above example of Company A purchasing goods worth $10000 and making a payment of $2000 at the time of purchase, the Goods Account will be debited by $10000. In contrast, Cash will be credited by $2000, and Accounts Payable will be credited by $8000. This increases the Goods inventory by $10000 and decreases Cash Balance by $2000. Accounts Payable stands at $8000 under the Current Liabilities section in the Balance Sheet of the Company.
When Company A decides to make the balance payment of $8000 to the seller, an offsetting entry is made. Accounts Payable is debited by $8000, and Cash/ Bank is credited by $8000. This means that the Accounts Payable balance has gone down by $8000, and Company’s Cash or Bank balance has been reduced by $8000. Subsequently, Accounts Payable goes down by $8000 under the Current Liabilities section in the Balance Sheet.
Accounting Entry for the Seller Company
The opposite of Accounts Payable is Accounts Receivable for the seller Company. In the books of the seller Company B, Trade Debt will be recorded under the head Accounts Receivable. This is shown under the head Current Assets in the Balance Sheet. At the time of sale, Accounts Receivable will go up by the Amount Company has to receive at a later date for Goods supplied. Its Cash/ Bank balance will go up after receiving the due payment. Subsequently, Accounts Receivable will go down by that amount.
Advantages of Trade Debt
There are numerous advantages of Trade Debt. Some of them from the buyers’ point of view are:
Trade Debt is a form of interest-free finance. It supports business growth without affecting the Company’s cash flow.
Discount on early payment
Suppliers often give discounts if payment is made within or before a stipulated time period. This means savings for the buyer.
Easy and Hassle-free form of Finance
Most importantly, trade debt does not require any special sanctions from any authority and is easily manageable in the books of Accounts. It also does not involve any legal formality.
Advantages of Trade Debt from the suppliers’ point of view are:
Power of Differentiation
Trade Debt gives suppliers the power of differentiation from other sellers. This is an additional facility not necessarily being provided by others. Therefore buyers will tend to buy more from suppliers giving the facility of Trade Debt.
Higher Sales and Revenue
Buyers tend to buy more if Trade debt is available. They don’t have to worry about making an immediate payment for the goods. Hence it results in higher sales and revenue for the supplier.
Disadvantages of Trade Debt
Trade Debt has some disadvantages too. Some of them from the buyers’ point of view are:
The opportunity cost of Trade Debt
Buyers cannot benefit from Cash Discounts offered by a supplier when payment is made immediately at the time of purchase. Hence, there is an opportunity cost of Trade debt, and the buyer might have to pay a bit extra.
High Product Prices
Suppliers tend to charge higher prices for goods under the Trade Debt facility. The buyer cannot bargain much if the supplier is offering this facility. As a result, the buyer ends up paying a higher price for the product.
Damage to Goodwill
The buyer might be unable to make timely payments to the supplier due to any unforeseen situation. This results in damage to the goodwill of the buyer in the market. Other suppliers, too, will avoid supplying goods to the buyer in the future.
Some disadvantages from the suppliers’ point of view are:
Companies can lose a lot of money by way of trade defaults if buyers with good credit history and goodwill are not chosen. Due care and diligence have to be observed by the seller.
Sellers may have to give discounts to the buyers to receive timely payments for their supplies. As a result, proper accounting and provisions for these discounts have to be made.
Trade Debt can result in higher trade volumes for both parties. It can be a win-win situation for both the buyer and seller if used judiciously.