While business firms would like to sell on cash, the pressure of competition and the force of custom persuade them to sell on credit. Firms grant credit to facilitate sales. It is valuable to customers as it augments their resources – it is particularly appealing to those customers who cannot borrow from other sources or find it very expensive or inconvenient to do so.
The credit period extended by business firms ranges from 15 days to 60 days. When goods are sold on credit, finished goods get converted into accounts receivable (or sundry debtors as they are referred to in India) in the books of the seller. In the books of the buyer, the obligation arising from credit purchase is represented as accounts payable (trade creditors).
A firm’s investment in accounts receivable depends on how much it sell on credit and how long it takes to collect receivables. For example, if a firm sells Rs 1 million worth of goods on credit a day and its average collection period is 40 days, its accounts receivable will be Rs 40 million. Accounts receivable constitute the third most important asset category for business firms, after plant and equipment and inventories. Hence, it behooves on a firm to manage its credit well.
Terms of payment:
Terms of payment vary widely in practice. At one end, if the seller has financial sinews, it may extend liberal credit to the buyer till it concerts goods bought into cash. At the other end the buyer may pay cash in advance to the seller and finance the entire trade cycle. Most commonly, however, some in between arrangement is chosen wherein the trade is financed partly by the seller, partly by the buyer, and partly by some financial intermediary. The major terms of payment are discussed below:
Cash terms: When goods are sold on cash terms, the payment is received either before the goods are shipped (cash in advance) or when the goods are delivered (cash on delivery). Cash in advance is generally insisted upon when goods are made to order. In such a case, the seller would like to finance production and elimination marketing risk, Cash on delivery is often demanded by the seller if it is in a strong bargaining position and/or the customer is perceived to be risky.
Open Account: Credit sales are generally on open account. This means that the seller first ships the goods and then sends the invoice (bill), The credit terms(credit period, cash discount for prompt payment, the period of discount and so on) are stated in the invoice which is acknowledged by the buyer. There is no formal acknowledgement of indebtedness by the buyer.
Credit Period: The credit period refers to the length of time the customer is allowed to pay for its purchases. It is usually mentioned in days from the date of invoice. If a firm allows 30 days of credit with no discount for early payment its credit terms are stated as net 30.
Cash Discount Firms generally offer cash discount to induce customers to take prompt payment. For example, credit terms of 2/10 net 30 mean that a discount of 2 per cent is offered if the payment is made by the tenth day; otherwise the full payment is due by the thirtieth day.
Billing to streamline billings, it is common practice to send a single bill every month. For example at the end of every month, the customer may be sent a consolidated bill for the purchases made from the 26th of the previous month to the 25th of the current month.
Consignment: When goods are sent on consignment they are merely shipped but not sold to the consignee. The consignee acts as the agent of the seller (consignor). The title of the goods is retained by the seller till they are sold by the consignee to a third party. Periodically, sales proceeds are remitted by the consignee to the seller.
Draft: When goods are shipped on open account or consignment, the seller does not have strong evidence of the buyer’s obligation. So, a more secure arrangement usually in the form of a draft is sought. A draft represents an unconditional order issued by the seller asking the buyer to pay on demand (demand draft) or at a certain future date (time draft) the amount specified on it. It is typically accompanied by shipping documents that are delivered to the drawee when he pays or accepts the draft. When the drawee accepts a time draft it becomes a trade acceptance. The seller may hold the acceptance till it matures or gets it discounted.
The draft performs three useful functions: (1) It serves as written evidence of a definite obligation. (2) It helps in reducing the cost of financing to some extent. (3) It represents a negotiable instrument.
Letter of credit: Commonly used in international trade, the letter of credit is now used in domestic trade as well. A letter of credit, or L / C is issued by a bank on behalf of its customer (buyer) to the seller. As per this document, the bank agrees to honor the draft drawn on it for the supplies made to the customer if the seller fulfills to conditions laid down in the L / C.
The L / C serves several useful functions: (1) It virtually eliminates credit risk, if the bank has a good standing (2) It reduces uncertainty as the seller knows the conditions that should be fulfilled to receive payment (3) It offers safety to the buyer who wants to ensure that payment is made only in conformity with the conditions of the L / C.