WHAT IS A TRADE CREDIT?
Trade Credit is an understanding between two parties who are into business with one another which allows the buying and selling of goods and services without transfer of money. A buyer can leave with goods or services without making any payment or with the promise to pay later. Mostly, trade credits are offered over a period of 7, 30, 60, 90 or 120 days or as may be determined by the supplier.
Since trade credits are based on the agreement between the seller and the buyer, the terms of the agreement will contain the time the deal was sealed, discount allowed and any form of trading instrument that was used.
For example, a credit term written as 4/10, net 30 implies that the customer has a period of 30 days from the date provided on the invoice to pay the seller. The number 4 determines the discount in percent that will apply to the total sales price if the customer can settle the terms of payment in 10days.
In a situation that the terms of sale reflected net 7, then it will be required that the customer pays up in 7days from the date of the invoice without any discount payment made before the due date.
When a firm extends trade credits to a customer it is reflected as accounts receivable but when trade credits are extended to a firm by suppliers, it reflects as accounts payable.
Trade credits can be taken as a short-term debt which has not been associated with interests.
TRENDS IN TRADE CREDIT-
Businesses with less financing options can take advantage of the opportunities that abound in trade credits. The recession which took place in 2008 led to a decline in financing options available for small businesses; especially in debt and equity financing.
Evidence of the limitations in traditional financing options for small businesses is seen in the increase in alternative financial sources such as peer-peer-lending and crowdfunding.
Reports have that trade credits in countries outside the US is about 20% of all externally financed investments. The survey showed that Bank credit was the most patronized form of financing apart from trade credits. This proved that trade credit is a highly significant financing option in all countries of the world.
TERMS AND CONCEPTS RELATED TO TRADE CREDIT-
The impact of trade credits on the financing of businesses has been significant and is linked to various concepts. These concepts are credit rating, buyer’s credit, and tradeline.
Credit rating: this considers the creditworthiness of the buyer based on its reputation for timeliness in debt repayment and other factors. Business or individuals with low credit rating will not be granted trade credits.
Buyer’s credit: the loans that are provided to importers to fund the purchase of capital goods or relative services, especially in international trades, is known as buyer’s credit. Different agencies across the borders are often involved and the least amount of the loan is a few million dollars.
Tradeline: credit reporting agencies usually receive credit account reports which are known as tradeline. Example of this is Fitch.
PERIOD OF CREDIT-
Different industries offer varying credit periods. For example, if a jewelry store sells out a diamond ring for 5/30 net 3 months, a food seller can decide to sell for net 4. However, three factors which a firm must consider for its credit period are:
- The probability that the buyer will pay – in a situation that the buyers are involved in high risk businesses, a firm may limit its willingness to trade on credits.
- Size of the account – when the size of the account is small, the credit period will be shortened since in most cases; managing of smaller accounts is costlier.
- The extent to which the goods can perish – such goods that perish within a short time has a low collateral value and must be offered the very low amount of credit.
INSTRUMENTS FOR TRADE CREDIT-
Many of the credits offered operate with an open account. This implies that an invoice is the only formal credit instrument that can be used with the goods supplied and on which the customer signs to prove that the goods have been received. After the receipt of the goods, the supplier and the buyer will record the transaction in their account books.
In other instances, the customer can sign a promissory note especially when the goods are large and there could be a problem in receiving the supply.
The essence of promissory notes is to eliminate problems that may arise after credit agreements. Note that promissory notes are signed only after the goods have been delivered.
Another way that a credit commitment is obtained from a customer before delivery of the goods is by the commercial draft. The supplier can get part of the payment from the buyer by writing to demand a specific amount to be paid in a specific date through the commercial draft.
The draft received will be sent to the buyer’s bank with the invoice of which the buyer must sign before turning over the invoice. It is only after the payment that the goods can be shipped to the buyer. In conditions that immediate payments are demanded, it is called a sight draft.
When the signed draft is below the seller’s expectation, the supplier may request that the bank pays the for the balance and collect the same amount from the buyer. The document that the bank forwards to the seller to show acceptance is called bank’s acceptance. It is because of the reputation of the bank that the bank’s acceptance will become a liquid document. The transaction will be carried out between the seller and the buyer while the bank acts as a secondary market.
ANALYSIS OF TRADE CREDIT-
It is the responsibility of the firm to factor out customers who will pay and those that will not. These factors that are used to distinguish the two categories of customers are:
- Financial statement – customers can supply financial statements to firms which will be used to determine their probability of payment of the loan.
- Customer payment history – the reputation of the customer on payments made to other firms is a determinant if the company will be paid.
- Banks – banks take up the responsibility of assisting their business customers in fetching creditworthiness information of other firms.
- Customer’s reputation of payment with the firm – this is the best way of obtaining the estimates on a customer’s probability of paying the credit offered.
THE 5 C’s of CREDIT
One of the most obvious ways to obtain the creditworthiness of a customer is by using the 5 C’s of credit. These are:
- Character – this defines the willingness of the buyer to meet with the obligations of credit.
- Capacity – the ability of the customer to make payments despite operating on a limited cash flow.
- Capital – this is defined by the customer’s financial reserves.
- Collateral – this is the asset that is pledged against a default.
- Conditions – this considers the existing or general economic conditions.
TRADE CREDIT IN THE REAL WORLD
In the real world, trade credit offers some form of assistance to those businesses with a limited avenue of financing. Small businesses with low credit history may have difficulties in obtaining financial assistance from banks and other lending institutions.
ALTERNATIVES TO TRADE CREDITS-
A major alternative to trade credit is when the trader is offered goods on consignment by the supplier. This is mostly seen in gift shops where the ownership of the goods is retained by the supplier until it sold by the trader.
RECENT RULES BY RESERVE BANK OF INDIA (RBI) ON TRADE CREDITS-
- The banks had been clarified that the period allowed for trade credits for imports should be in conformity with the operating cycle and the general transaction period.
- The Reserve Bank of India mentions that for availing of trade credit, the period of trade credit should be linked with the trade transaction operating cycle.
EXTERNAL COMMERCIAL BORROWINGS (ECB)-
Trade credit is a facility that the buyer and the seller create at the point of exchange of goods and services. In any instance, trade credits are always in the form of a supplier’s credit and buyer’s credit. External Commercial Borrowing is permitted where the supplier or the party that offers the sale is outside the shores of India. The maturity period of ECB should not exceed five years.
Trade credits are only available for imported goods only if it is permitted in the Foreign Trade Policy.
ECB is permitted in the form of trade credit under approval route and automatic routes. However, trade credits for imported goods can be over $20 million under automatic route but anything more than this is provided under the approval route.
Import of capital and non-capital goods can be availed for trade credits. The rule provides that maturity for trade credit with non-capital goods cannot exceed one year starting from the date of the shipment. Therefore, capital goods only are permitted to hold the maximum maturity period of five years.
At no instance should the maturity period be extended beyond the approved period of five years and six months as may be applied.
WHAT ARE THE VARIOUS TYPES OF EXTERNAL COMMERCIAL BORROWINGS?
There are many types of ECBs and ways it could be raised to facilitate its purpose. These include:
- Loans through banks and other lending bodies.
- Capital market instruments in the form of floating rate notes, convertible bonds, non-convertible bonds, FCCB and FCEB.
- Buyer’s and Seller’s credit
- Financial lease
REQUIREMENTS WITH RESPECT TO CURRENCIES OF ECB-
The acceptable currency for the raising of ECB is the Indian Rupee (INR) and or any currency that can be converted. An entity that has raised ECB in INR denominations is prohibited from converting the liability that results from the ECB into any liability in foreign currency.
REQUIREMENT FOR THE USE OF ECB FOR REAL ESTATE ACTIVITIES
ECB is prohibited for all activities that are under the real estate sector. No individual or entity is permitted as eligible to use or raise ECB about to real estate.
CAN ECB BE AVAILED FOR PAYMENT OF DOMESTIC INR LOAN?
Yes. This is only permitted for Track I and Track III if ECB is raised from a foreign equity holder.