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Principles of Finance

19.2 What Is Trade Credit?

Principles of Finance19.2 What Is Trade Credit?

By the end of this section, you will be able to:

  • Compute the cost of trade credit.
  • Define cash discount.
  • Define discount period.
  • Define credit period.

Trade credit, also known as accounts payable, is a critical part of a business’s working capital management strategy. Trade credit is granted by vendors to creditworthy companies when those companies purchase materials, inventory, and services.

A company’s purchasing system is usually integrated with other functions such production planning and sales forecasting. Purchasing managers search for and evaluate vendors, negotiate order quantities, and prepare purchase orders. In carrying out the purchasing process, credit terms are granted by the company’s vendors and purchases of inventory and services can be made on trade credit accounts—allowing the purchaser time to pay. The purchaser carries an accounts payable balance until the account is paid.

Trade credit is referred to as spontaneous financing, as it occurs spontaneously with the gearing up of operations and the additional investment in current assets. Think of it this way: If sales are increasing, so too is production. Increased sales mean more current assets (accounts receivable and inventory), and increased sales mean increases in accounts payable (financing happening spontaneously with increased sales and inventory purchases). Compared to other financing arrangements, such as lines of credit and bank loans, trade credit is convenient, simple, and easy to use.

Once a company is approved for trade credit, there is no paperwork or contracts to sign, as is the case with various forms of bank financing. Invoices specify the credit terms, and there is usually no interest expense associated with trade credit. Accounts payable is a type of obligation that is interest-free and is distinguished from debt obligations, such as notes payable, that require the creditor to pay back principal and interest.

How Trade Credit Works

Trade credit is common in B2B (business to business) transactions and is analogous to consumer spending using a credit card. With a credit card, a consumer opens an account with a credit limit. Most trade credit is offered to a company with an open account that has a credit limit up to which the company can purchase goods or services without having to pay the cash up front. As long as the payments are made in accordance with the terms of the agreement (also called credit terms), no interest or additional fees are charged on the credit balance except possibly for a fee for late payment.

Initially, the vendor’s credit department approves both a trade credit limit and credit payment terms (i.e., number of days after the invoice date that payment is due). Timely payments on accounts payable (trade credit) helps create a credit history for the purchasing firm.

Trade Credit Terms

Trade credit arrangements often carry credit terms that offer an incentive, called a discount, for a company (the buyer) to pay its bill within a relatively short period of time. Net terms, also referred to as the full credit period, are the number of days that a business (purchaser) has before they must pay their invoice. A common net term is Net 30, with payment due in full within 30 days of the invoice.

Many vendors also offer cash discounts to customers that pay their bill early. A company’s invoice that specifies payment terms of “2/10 n/30” (stated as: “two ten net 30”) would allow a 2 percent discount if the buyer’s account balance is paid within 10 days of the invoice date; otherwise, the net amount owed would be due in 30 days. The “10 days” in the example is the discount period—the number of days the buyer has to take advantage of the cash discount for an early payment, also known as quick payment.

For example, Jackson’s Premium Jams Inc. received a $10,500 invoice for the purchase of jelly jars. The invoice has payment terms of 2/10 n/30. Jackson’s pays the bill within 10 days of the invoice date. Jackson’s payment would be $10,290 = ($10,500 × (100%  2%))$10,290 = ($10,500 × (100%  2%)). The effect of taking a discount because of a quick payment is a lowering of the cost of inventory in the case of purchases of materials (for a manufacturer), merchandise (for a retailer or wholesaler), and operating expenses (for any company that “buys” services using trade credit). In Cost of Trade Credit, there is an example that shows the high annualize opportunity cost (36.73 percent) of not taking advantage of cash discounts.

Concepts In Practice

Trade Credit of International Trade

When international trade occurs, two important documents are commonly required: a letter of credit and a bill of lading. A letter of credit is issued by a financial institution on behalf of the foreign buyer (importer). The bill of lading is a legal document that gives proof of a contract between a transportation company and the buyer and is one important piece of documentation that allows the buyer to draw on the letter of credit. A bill of lading serves as a document of title and proof of receipt of goods by the shipper.

The letter of credit secures a promise of payment to the seller (exporter) provided that the terms of the sale are met. For an international trade transaction, the letter of credit is the main mechanism that establishes a liability for the buyer. Instead of a trade payable, the buyer uses a line of credit from a bank.

Cost of Trade Credit

Trade credit is often referred to as a no-cost type of financing. Unlike with other credit arrangements (e.g., bank loans, lines of credit, and commercial paper), there is usually no interest expense associated with trade credit, and as long as your account does not become delinquent, there are no special fees. Some accounts payable arrangements specify an interest penalty or a late fee when the account goes delinquent, but as long as payments are made on time, trade credit is thought of as a low-cost source of working capital.

However, there is one possible cost associated with trade credit for companies that don’t take advantage of cash discounts when offered by sellers. Using accounts payable to purchase goods and services can involve an opportunity cost—a cost of the forgone opportunity of making a quick payment and benefiting from a cash discount. A business that does not take advantage of a cash discount for early payment of trade credit will pay more for goods and services than a business that routinely takes advantage of discounts.

The annual percentage rate of forgoing quick payment discounts can be estimated with the following formula:

APR of Forgoing Quick Payment Discounts = 360Full Credit Period - Discount Period ×Discount100 - Discount %APR of Forgoing Quick Payment Discounts = 360Full Credit Period - Discount Period ×Discount100 - Discount %

Example: Novelty Accessories Inc. (NAI) purchases products from a vendor that offers credit payment terms of 2/10, net 30. The annual cost to NAI of not taking advantage of the discount for quick payment is 36.73 percent.

APR of Quick Payment Discounts=36030 -10×2%100%-2%= 36020 × 2%98%=36.73%APR of Quick Payment Discounts=36030 -10×2%100%-2%= 36020 × 2%98%=36.73%
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