Trade Credit: Meaning and Management (With Formula)

In this article we will discuss about:- 1. Meaning of Trade Credit 2. Terms in Trade Credit 3. Cost of Taking Credit 4. Management of Trade Credit.

Meaning of Trade Credit:

Trade credit is a spontaneous source of finance which is normally extended to business organization depending on the custom of the trade and competition prevailing in the industry and relationship of the suppliers and buyers. This form of business credit is more popular since it contributes to about one-third of the total short-term credit.

The dependence on this source of working capital finance is higher due to negligible cost of finance as compared to negotiated finances. It is a facility whereby business firms are allowed by the suppliers of raw materials, services, components and parts, etc., to defer the immediate payment to a definite future period.

Trade credit is generated when a company acquires supplies, merchandise or materials and does not pay for them immediately. If a buyer is able to get the credit without any legal evidence or instrument, it is termed as ‘open account trade credit’ and appears in the balance sheet of the buyer as ‘sundry creditors’.

When an instrument is given, notably negotiable instrument, in acknowledgement of the debt, the same appears in the final statement as ‘bills’ or ‘notes payable’. Due to its reasons of simplicity, easier to obtain, no explicit costs, the dependence on this source is much higher in all big or small organizations.

Especially, for small enterprises this form of credit is more helpful on account of their difficulties in acquiring capital from banks and other sources in capital markets. There is a linear correlation of trade credit with the volume of sales. An increase or decrease in the purchase of goods and services by a business organization will have reflection on the source of finance enjoyed in the form of trade credit.

Terms in Trade Credit:

The trade credit is extended generally on the following terms and conditions:

i. Maximum Credit Limit:

It is a term which determines the extent to which a customer is eligible for trade credit. An unlimited trade credit cause hardships both to the buyer and the seller. The trade credit limit is determined by factors like creditworthiness of the buyer, volume of business expected, past record with regard to payment, nature of business, etc.

ii. Credit Period:

It is the period of time for which trade credit is made available to the company by the suppliers. Like the amount of credit, credit period too is determined by various of factors.

iii. Cash Discount:

It is a discount or reduction in debt allowed by creditors to their debtors to encourage them to pay their dues before the expiry of the credit period.

iv. Starting Date:

Another important term in trade credit is starting date. Credit period and discount period are meaningless without this term. A supplier who requires payment in 45 days must stipulate when this period of 45 days begins. It could begin from the day the goods despatched, the date the goods is received invoice date or some other date.

Cost of Taking Credit:

Increase in Price of goods:

The trade credit has no explicit cost. This has led to the wrong notion that trade credit is a cost-free source. However, like a scarce economic source it passes implicit costs or opportunity costs.

A firm has to evaluate the implicit costs involved in using trade credit and compare this cost with the explicit cost of a negotiated source to justify its employment in financing working capital requirements. It is well accepted fact that credit purchases always costs more than cash purchases.

The sellers incur the following additional costs when goods are sold on credit:

(a) The funds are invested in the form of book debts. There are explicit costs involved in this investment.

(b) The sellers incur the cost of cash discount if availed by the buyers.

(c) The sellers undergo the risk of bad debts and often bear them.

(d) Direct costs are incurred to monitor, extend and collect out standings, like credit and collection department expenses, legal expenses, etc.

All these costs add to the costs of purchases. A rational seller would like to recover all these charges by increasing the selling prices of goods sold on credit. The estimating of the amounts to allow for these items will tend to be influenced by past experience, current practice and future expectations.

For example, a sale to a normal customer amounting to Rs. 1,500 in value with a sale to an occasional trade customer who expects a trade discount of 33 ⅓ per cent, giving a value for the same order of only Rs. 1,000. The credit term often extended by the selling firm by offering discount for early payment or if period of payment is more than stipulated period, no discount is offered.

If the selling firm offer a 2 per cent discount for payment within the first 10 days and ask payment within 30 days without discount. The decision whether the purchasing firm should pay promptly and take the discount, or accept the 30 days financing with no explicit cost, depends on the actual percentage cost of taking the financing relative to the discount and how much the firm is willing to pay for its short-term financing.

The percentage cost of the trade credit is given by the following equation:

In most circumstances, it is better to take the discount, unless short-term rates are very high or the firm is in dire need of short-term financing and is unable to secure a cheaper financing source.

It is always wise to pay on either the last day of the discount period or the last day of the net period. Some firms may not take the prompt payment discount and not pay the net amount by the due date.

Loss of Goodwill:

Sometimes, firms may adopt a policy of stretching accounts payable, delaying payment beyond the credit period. A firm that chronically makes its payments late is certain to irritate its suppliers.

The costs of bad relations with suppliers are difficult to quantify, but they are real and likely to be expensive to a firm adopting a policy of late payment. For example, in extreme cases the supplier may refuse to ship to the offending firm or demand payment before shipping.

Costs of Administration and Accounting:

The firms enjoying trade credit must pay the dues in time, for that proper accounting procedures are to be adopted and it takes the administrative time in keeping track of payments to creditors without default.

Restrictions in Supply:

If credit is taken, the suppliers may impose restrictions on company to place orders for some minimum lots of quantity or even regularly on periodical basis.

Management of Trade Credit:

The firm should exploit the possibilities of trade credit to the full extent, because it is an important source of financing working capital needs of the firm. But before opting for taking trade credit, the firm should negotiate with suppliers for maximum credit period without causing embarrassment to the supplier.

It can also negotiate for rate of cash discount, if purchases are made on cash basis. The firm require to analyze the benefits arising from cash discount and credit period, and the selection of mode of purchase is need to be linked with the profitability of the firm.

A proper management policy is called for planning and control of trade credit. A lackluster policy may result in using a source with an implicit cost, much higher than the explicit cost of a negotiated source thus, resulting in eroded profitability. To facilitate the management’s decision making, the following financial ratios can be of great use:

Trade Credit to Total Current Assets Ratio:

This ratio indicates the magnitude of the use of trade credit in financing total current assets of a firm. The lower the ratio, the better will be liquidity position of the firm.

Trade credit/Total current assets

Trade Credit to Total Current Liabilities Ratio:

This ratio indicates the proportion of trade credit to total current liabilities. It speaks on the financing mix adopted by the company. A high ratio means increased dependence on spontaneous sources and difficulties in getting funds from negotiated sources. It is a pointer at impending financial difficulties.

Trade Credit to Sales Ratio:

This ratio is also very useful from the point of inter-period and inter-firm comparisons.

Percentage Change in Trade Credit to Percentage Change in Sales Ratio – This fourth ratio indicates the behavioural relationship between sales and trade credit. Generally speaking, increasing sales demand increasing use of trade credit facilities, the rate of change in sales must always be higher than the rate of change in trade credit. A quotient of 1 signifies proportionate relationship between the two. The lower the quotient, the better will be the management of trade credit.