Cost of Trade Credit

The rate of discount benefit sacrificed by the business for making payment after a certain time period in future whether then making payment earlier by enjoying discount benefit is known as cost of trade credit for making rate in payment the  supplier may impose late payment penalty that is also a part of cost of trade credit. 

This cost is known as visible cost of trade credit. The loss of reputation or goodwill of the business sector for making less payment against trade credit and loss of availability of suppliers for purchasing required items or materials are known as invisible or hidden cost of trade credit.

We can also distinguish between prompt payment and delayed payment practices. By prompt, we mean those situations in which the firm pays off the trade credit exactly on time. There are two such possibilities. 

If a cash discount is offered, paying on time means paying on the discount date. But if cash discount is not offered, prompt payment means payment on the due date. However, if a cash discount is offered but not taken, or if the full bill is not paid by the due date, the firm is making a delayed payment.

Example:

Suppose a firm sale $100 on credit are 2/15, net 75

Now the cost of trade credit = x/100-x*365/ (z-y)

[x=2, y=15, z= 75]

= 2/100-2 * 365/75-15

= 2/98 * 365/60

= .1241%

= 12.42%

But if the credit terms are 2/5, net 75 and stretches payable is 20 days, than

The cost of trade credit = x/100-x*365/ (z+ k-y)

[x=2, y=15, z= 75, k= 20]

= 2/100-2 * 365/75+20-15

= 2/98 * 365/80

=9.31%

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.

What is Trade Credit ?

Definition

Purchasing required materials, products, and other relevant items from suppliers on account with the agreement of making payment after a certain time period in further is known as trade credit.

This includes open account where there is no written or formal document for credit transaction between two parties and notes payable where there will be maintaining written and formal document signed by both parties.

A major source of funds for U.S. business firms, trade credit traditionally provides approximately 6 percent to 12 percent of the firm’s total financing, depending on the kind of business firm is in and the size of the firm.

Wholesale and retail companies have historically been heavy users, as have manufacturers. 

Small firm considerations

Small companies tend to rely on trade credit more than large ones because these companies are generally less able to access the capital and money markets, where trade credit can be obtained readily by any firm with a reasonable financial record.

Advantages of Trade Credit

1.       Availability: Except for firms in financial trouble, trade credit id almost automatic, and no negotiations or special arrangements are required to obtain it. This availability is important to smaller companies that may have difficulty obtaining funds elsewhere.

2.      Flexibility: If the firm’s sales increase, causing its purchases of goods and services to increase, trade credit will grow automatically. Likewise, if the firm’s sales decrease, causing purchases needs to drop, trade credit will likewise decrease.

3.      Few or no restriction: In general, trade credit terms are much less restrictive than those of negotiated sources of fund. As we will see, when the firm negotiates for short-term funds, it may have restrictions imposed on its financial activities by the lenders.

Disadvantages of Trade Credit

1.       Suppliers may not be agreed to supply required items on credit for the time period.

2.      Sometimes it may be more costly for the business.