Trade liabilities are a form of short-term financing common to almost al businesses. In fact, they are collectively the largest source of short-term funds for business firms. In an advanced economy, most buyers are not required to pay for goods on delivery but are allowed a short deferment period before payment is due. During this period the seller of goods extends credit to the buyer. Because suppliers are more liberal in the extension of credit than are financial institutions, Companies especially small ones rely heavily on this trade credit.
Of the three types of trade credit — pen accounts, notes payable, and trade acceptances — the openâ€“account arrangement is by far the most common kind. With this arrangement the seller ships goods to the buyer and sends an invoice that specifies the goods shipped 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 generally extends credit based on a credit investigation of the buyer. Open account credit appears on the buyerâ€™s balance sheet as accounts payable.
In some situations promissory notes are employed instead of open account credit. The buyer signs note evidence a debt to the seller. The note calls for the payment of the obligation at same specified future date. This arrangement is employed when the seller wants the buyer to acknowledge the debt formally. For example, a seller might request a promissory note from a buyer if the buyerâ€™s open account became past due.
A trade acceptance is another arrangement by which the indebtedness of the buyer is formally recognized. Under this arrangement, the seller draws a draft on the buyer, ordering the buyer to pay the draft at some future date. The seller will not release the goods until the buyer accepts the time daft. 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 on 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.
Terms of Sale: 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 the 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 â€œnet periodâ€? within which payment is expected and according to the terms of the cash discount, if any
1. COD and CBD — No trade Credit. COD means Cash on delivery of goods. The only risk the seller undertakes is that the buyer may refuse the shipment. Under such circumstances, the seller will be stuck 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.
2. Net Period — Seller specifies the bill must to be paid within a period of 30 days. If the seller bills are on monthly basis, it might require such terms as â€œnet 15, EOMâ€? meaning that all goods shipped before the end of the month must be paid by the 15th of the following month.
3. Net Period — The terms â€œ2/10 net 30 indicate that the seller offers a 2% discount if the bills are paid within 10 days; otherwise, the buyer must pay the full amount within 30days. A cash discount differs from a trade discount and from quantity discount. A trade discount is greater for one class of customers than for others.
4. Seasonal Dating: In a seasonal business, sellers frequently use particular dates to encourage customers to place their orders before a heavy selling period.