Different types of Trade Credit and Some Credit Terms

Types of Trade Credit

An open account sale, the seller ships the merchandise to the buyer, and the trade credit simply appears on the buyer’s books as an account payable. The seller’s confidence in entering this kind of arrangement usually comes from checking the credit worthiness of the buyer and/or the history of previous business transactions with the buyer. Because open-account transactions are the most widely used type of trade credit, a firm would be in trouble if its credit ratings deteriorated to the point where this kind of credit became difficult to obtain.

When the buyer signs a promissory note to obtain trade credit, it shows up on the buyer’s balance sheet as a trade note payable. The note will have a specified future payment date and is typically used when the seller is less sure the buyer will pay for the delivered goods. 

Although a more formal arrangement than the open account, it is actually no more legally binding. It does, however, document the debt and, when presented for collection through a bank, gives the seller more leverage in forcing collection.

Trade notes payable are used routinely in some industries that deal with extremely expensive merchandise, like fuels and jewelry.

Credit terms

Credit terms refer to the conditions under which credit is granted. The three major items of the credit terms are:

Due date

Cash discount

Discount rate

The terms are usually states as follows:

X/y, net z

Where X is the cash discount (percent), Y is the discount date (days), and z is the due date (days).

Example: credit terms are 5/20, net 40 that means a 5 percent discount is allowed if the bill is paid by the 20^th day. If the discount is not taken, the full amount of the bill is due by the 40^th day.

If the buyer wishes to take the discount, he must pay the bill- less the discount- by the discount date. Suppose a buyer of $5,000 worth of merchandise who is offered term of 5/20, net 40, must pay $4750 any time up to the 20^th day. There is no advantage in paying after 20^th day, however. Indeed, because of the time value of money, it would not make financial sense to do so without some inducement being offered. If the discount is not taken, $5000 is due by the 40^th day. Again if the discount is not taken or if none is offered, it would not make financial sense to pay before the due date.

Some important point

a.      This dependence on trade credit by small companies is quite important during tight money periods, when raising fund from negotiated sources is difficult for all companies, but particularly so for small ones.

b.      Other notes payable that are not trade notes payable are notes issued to banks, employees, officers, and stockholders.

c.       A trade acceptance is an alternative method of formally acknowledging the debt the buyer owes the seller. The seller draws a bank draft (trade acceptance) on the buyer. This draft is a legal instrument proclaiming that the buyer will pay the bank the amount of the bill on same specified future date. The seller sends the merchandise after the buyer signs the draft; on the due date, the banks ask for the payment and forward this payment(less a service charge) to the seller.

Using trade acceptances has several advantages for the seller. As with notes payable, the seller has forced the buyer to acknowledge in writing that a debt exist. 

Most important, the seller has employed the bank to make collection, and most companies would be much more hesitant about not paying an acceptance to the bank promptly than about not paying an open-account trade credit to supplier promptly.

Last if the buyer has a good reasonable credit rating, the trade acceptance is marketable and may be sold at a discount (for less face value) to investors.