Whenever a business receives merchandise ordered from a supplier and is then permitted to wait a specified period of time before having to pay, it is receiving trade credit. In the aggregate, trade credit is the most important source of short-term financing for business firms. Smaller businesses in particular usually rely heavily on trade credit to finance their operations because they are often unable to obtain funds from banks or other lenders in the financial markets.
Most trade credit is extended on an open account basis. A firm sends a purchase order to a supplier, who then evaluates the firm’s creditworthiness using various information sources and decision criteria. If the supplier decides to extend the firm credit, it ships the ordered merchandise to the firm, along with an invoice describing the contents of the shipment, the total amount due, and the terms of sale.When the firm accepts the merchandise shipped by the supplier, it in effect agrees to pay the amount due as specified by the terms of sale on the invoice. Once it has been established, trade credit becomes almost automatic and is subject to only periodic reviews by the supplier. Open account trade credit appears on the balance sheet as accounts payable.
Promissory notes are sometimes used as an alternative to the open account arrangement. When a company signs a promissory note, which specifies the amount to be paid and the due date, it is formally recognizing an obligation to repay the credit. A supplier may require a company to sign a promissory note if it questions the company’s creditworthiness. Promissory notes usually appear on the balance sheet as notes payable.
Credit terms, or terms of sale, specify the conditions under which a business is required to repay the credit that a supplier has extended to it. These conditions include the length and the beginning date of the credit period, the cash discount (if any) given for prompt repayment, and any special terms, such as seasonal datings.
Cost of Trade Credit
Trade credit is considered a spontaneous source of financing because it normally expands as the volume of a company’s purchases increases. For example, suppose a company experiences increased demand for its products. As a result, the company increases purchases from suppliers by 20 percent from an average of $10,000 per day to an average of $12,000 per day. Assuming that these purchases are made on credit terms of “net 30” and that the company waits until the last day of the credit period to make payment, its average accounts payable outstanding (trade credit) will automatically increase by 20 percent from $300,000 ($10,000*30) to $360,000 ($12,000*30).
Because trade credit is flexible, informal, and relatively easy to obtain, it is an attractive source of financing for virtually all firms, especially new and smaller firms. To make intelligent use of trade credit, however, a firm should consider the associated costs. Unlike other sources of financing, such as bank loans and bonds, which include explicit interest charges, the cost of trade credit is not always readily apparent. It may appear to be “cost-free” because of the lack of interest charges, but this reasoning can lead to incorrect financing decisions. Obviously, someone has to bear the cost of trade credit. In extending trade credit, the supplier incurs the cost of the funds invested in accounts receivable, plus the cost of any cash discounts that are taken.
Normally, the supplier passes on all or part of these costs to its customers implicitly as part of the purchase price of the merchandise, depending on market supply and demand conditions. If a company is in a position to pay cash for purchases, it may consider trying to avoid these implicit costs by negotiating lower prices with suppliers. If the terms of sale include a cash discount, the firm must decide whether or not to take it. If the firm takes the cash discount, it forgoes the credit offered by the supplier beyond the end of the discount period. Assuming that the firm takes the cash discount and wants to make maximum use of the credit offered by suppliers, it should pay its bills on the last day of the discount period. Under these conditions, trade credit does represent a “cost-free” source of financing to the firm (assuming that no additional discounts are available if the firm pays cash on delivery or cash before delivery).
If a company forgoes the cash discount and pays bills after the end of the discount period, a definite opportunity cost of trade credit is incurred. In calculating the cost of not taking the cash discount, it is assumed that the company will make maximum use of extended trade credit by paying on the last day of the credit period. Paying after the end of the credit period, or stretching accounts payable, subjects the company to certain other costs. The annual financing cost of forgoing a cash discount is calculated using Equation 16.10. In this application, the AFC is equal to the fractional interest cost per period times the number of borrowing periods per year:
AFC = (Percentage Discount/100-Percentage Discount) x (365/Credit Period - Discount Period)
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