Terms of Trade Credit
Terms of credit vary considerably from industry to industry. Theoretically, four main factors are determined the length of credit allowed.
- The economic nature of the product: products with a high sales turnover are sold on short credit terms. If the seller is relying on a low profit margin and a high sales turnover, he cannot afford to offer customers a long time to pay.
- The financial circumstances of the seller: if the seller’s liquidity position is weak he will find it difficult to allow very much credit and will prefer an early cash settlement. If the credit term is used as part of sales promotion then, he may allow more credit days and use other means for improving liquidity position.
- The financial position of the buyer. If the buyer is in weak liquidity position he may take long time to settle the balance. The seller may not be will to trade with such customers, but where competition is stiff there is no choice other than accepting such risk and improve on sales levels.
- Cash discounts: when cash discounts are taken into account, the cost of capital can be surprisingly high. The higher the cash discount being offered the smaller is the period of trade discount likely to be taken.
For a company, as a buyer having increased credit days may indicate that the enterprise is facing cash problems and is unable to settle their balance in good time, and this may result in loss of business. Allowing cash discounts to pass is also a cost to the business as outlined above. However, reducing the day’s payment to the supplier may also indicate that the company is not trusted by its suppliers. A company with a poor track record will always face difficulties in negotiating for more days, hence the short payment period.
- Sales ledger accounting, despatching invoices and making sure bills are paid.
- Credit management, including guarantees against bad debts.
- The provision of finance, advancing clients up to 80% of the value of the debts that they are collecting.
The factoring company will takeover the administration of receivable department, maintaining the sales records, credit control and the collection of receivables. It is claimed that the factor will be able to obtain payment from customers more quickly than if the company was to make collection on its own. The cost of this administrative service is a fee based on total value of debts assigned to the factor. The fee rate is based on work which is to be done and the risk level of bad debts.
For a fee the factor can provide up to 100% protection against non payment of approved sales. The factoring company will always assess the credit profile of an enterprise before entering into such an agreement. As outlined above the risk level of the company’s debts will be the main factor in determining the fee charge.
This is the main product which most factoring companies offer. Factor companies provide finance which is used to boost the working capital; of the business. The factoring is not as cheap as may be the bank overdrafts and because the bank borrowing is also flexible it is imperative that the company should approach the bank first. However, factoring can be particularly useful when a company has exhausted its overdraft and is not yet in position to raise new equity.
One of the most common used sources of short term of finance because of its cost and flexibility. When borrowed funds are no longer required they can quickly and easily be paid. It is also comparatively cheap because the risks to the lender are less than on the long-term loans, and all the loan interests are allowable tax expenses. The bank issue overdrafts with the right to call them in at short notice. Bank advances are, in fact payable on demand. Normally the bank assures the borrower that he can rely on the overdraft not being recalled for a certain period of time.
The borrower is required to use the overdraft to supplement the working capital shortfall. As the bank overdraft is payable on demand it is not wise to use the money in purchasing non current assets like machine. Financing of such assets should be made using long-term finance such as finance lease and loans. Any plans that involve an overdraft or short term loan should therefore refer closely to the company’s cash flow analysis so that it is quite clear how long the funds will be needed and when they can be repaid.
Another purpose for which bank overdraft might typically be used to iron out seasonal fluctuations in trade. The banks assist in providing temporary funds to finance production on the assumption that the goods or products will be sold in a later season. Agriculture is the obvious example of an industry where this type of borrowing is needed.