Trade Credit Financing

Trade credit is a form of short term financing common to almost all businesses. In fact, it is the largest source of short term funds for business firms collectively. In an advanced economy, most buyers are not required to pay for goods upon delivery but are allowed a short deferment period before payment is due. During this period, the seller of the goods extends credit to the buyer. Because suppliers generally are more liberal in the extension of credit than are financial institutions, small companies in particular rely on trade credit.

Of the three types of trade credit open account, notes payable, and trade acceptances by far the most common type is the open account arrangement. The seller ships goods to the buyer and sends an invoice that specifies the goods shipped, the price, the total amount due, and the terms of the sale. Open account credit derives its name from the fact that the buyer does not sign a formal debt instrument evidencing the amount owed the seller. The seller extends credit based upon a credit investigation of the buyer.

In some situations, promissory notes are employed instead of open account credit. The buyer signs a note that evidences a debt to the seller. The note itself calls for the payment of the obligation at some specified future date. Promissory notes have been used in businesses such as those dealing in furs and jewelry. This arrangement is employed when the seller wants the buyer to recognize the debt formally. For example, a seller might request a promissory note from a buyer if the buyer's open account became past due.

A trade acceptance is another arrangement by which the indebtedness of the buyer is recognized formally. Under this arrangement, the seller draws a draft on the buyer, ordering the buyer to pay the draft at some date in the future. The seller will not release the goods until the buyer accepts the time draft.' Accepting the draft, the buyer designates a bank at which the draft will be paid when it comes due. At that time, the draft becomes a trade acceptance; and depending upon the creditworthiness of the buyer, it may possess some degree of marketability. If the trade acceptance is marketable, the seller of the goods can sell it at a discount and receive immediate payment for the goods. At final maturity, the holder of the acceptance presents it to the designated bank for collection.

Because the use of promissory notes and trade acceptances is rather limited, the subsequent discussion will be confined to open account trade credit. The terms of sale make a great deal of difference in this type of credit. These terms, specified in the invoice, may be placed in several broad categories according to the net period within which payment is expected and according to the terms of the cash discount.

COD and CBD No, Extension of Credit. COD terms mean cash on delivery of the goods. The only risk the seller undertakes in this type of arrangement is that the buyer may refuse the shipment. Under such circumstances, the seller will be stuck with the shipping costs. Occasionally, a seller might ask for cash before delivery (CBD) to avoid all risk. Under either COD or CBD terms, the seller does not extend credit. CBD terms must be distinguished from progress payments, which are very common in certain industries. With progress payments, the buyer pays the manufacturer at various stages of production prior to actual delivery of the finished product. Because large sums of money are tied up in work in progress, aircraft manufacturers request progress payments from airlines in advance of the actual delivery of aircraft.

Net Period No Cash Discount. When credit is extended, the seller specifies the period of time allowed for payment. The terms "net 30" indicate that the invoice or bill must be paid within 30 days. If the seller bills on a monthly basis, it might require such terms as "net/15 EOM," which means that all goods shipped before the end of the month must be paid for by the fifteenth of the following month.

Net Period with Cash Discount. In addition to extending credit, the seller may offer a cash discount if the bill is paid during the early part of the net period. The terms "2/10, net 30" indicate that the seller offers a 2 percent discount if the bill is paid within 10 days; otherwise, the buyer must pay the full amount within 30 days. Usually, a cash discount is offered as an incentive to the buyer to pay early. In Chapter 14, we discussed the optimal cash discount the seller might offer. A cash discount differs from a trade discount and from a quantity discount, A trade discount is greater for one class of customers (e.g., wholesalers) than for others (e.g., retailers). A quantity discount is offered on large shipments. Datings. In a seasonal business, sellers frequently use datings to encourage customers to place their orders before a heavy selling period. A manufacturer of lawn mowers may give seasonal datings specifying that any shipment to a dealer in the winter or spring does not have to be paid for until summer. Earlier orders benefit the seller, who can gauge the demand more realistically and schedule production more efficiently. Also, the seller does not have to store finished goods inventory. The buyer has the advantage of not having to pay for the goods until the height of the selling period. Under this arrangement, credit is extended for a longer than normal period of time.