Credit Terms

Definition of Credit Terms


Credit terms are the terms which are being mentioned in the invoice at the time of buying of goods by the seller. The credit terms ensure that the customers are making the payment of the products in a proper way. It is a contract being made between buyer and seller regarding timing and the manner in which payment is required to be made for the goods. It lays down specific requirements regarding the payment terms and avoids any kinds of issues which are likely to rise to the organization. Therefore, it can be said that credit terms are negotiable terms being offered by the seller to the buyer. There is control over monthly and total credit amount which is to be paid by the organization. There are various organizations which have set up their own credit policies with the vendors and customers to whom the products are being sold on a regular basis. This is being carried out as credit purchases have an enhancement in the business operations and there is an increase in the level of sales as the buyers can make a purchase of the products even though, there is no money being available to the buyers. The establishment of credit terms is mostly being made on the basis of practices which are being followed in the industry at a particular point in time. 

            For every seller, the definition of credit terms is different from another. The reason behind this is that each and every business is different from another business. There are certain things which are to be taken into consideration by a person for the purpose of ensuring that, credit policies are being carried out well. The points to be considered include the following: 

  1. The time period for which the customer is being worked with the organization
  2. Discounts being offered for on-time payment
  3. Charging of late fees if buyers do not make payment on time.
  4. Terms and relations with vendors
  5. Information about payment history should be known
  6. Competitors and peers 

Examples of Credit Terms

            Credit is being offered to a particular customer for the purpose of ensuring that, early payment is being encouraged in the course of doing the tasks. The term structure is followed for credit terms would be regarding a number of days being given to the customer for the purpose of processing the payment. If the customer makes payment within 10 days then, the credit terms would be net-10 days. If the customer qualifies for 2% discount on making payment in 10 days then, the credit term being taken into consideration would be termed as 2/10. 

For deciding the level of credit being required to be offered, following tasks are to be taken into consideration by the organization. 

  1. Amount of credit is provided to the customer
  2. The time period for payment
  3. Discount terms for early payment
  4. Late payment             

Amount of Credit Extended to a Customer

            The total level of credit being extended by a customer to another customer is being termed as credit exposure. For example, if a bank has provided $100 million to an organization then, credit exposure of that organization would be at the level of $100 million. The organization which has highest credit rating is going to provide higher credit exposure in comparison to organizations which have a lower level of credit rating. The term credit risk and credit exposure are being used in an interchangeable manner. Credit risk makes a measurement of the vastness of the loss being incurred by the organization in the course of default which has arisen at a particular point in time. 

            A lender has certain ways to be used for ensuring that, credit exposure is being controlled to a certain extent. The organizations set up credit limits for different kinds of customers. In the course of this particular thing, it is being identified that the organization would work towards the area of ensuring that, it does not extend a higher level of credit to any other company instead of the companies which are likely to repay the loan in a positive way. There are certain standardized methods being used for the purpose of ensuring that, credit exposure is being limited. In the course of credit exposure, the methods to be used would include credit card swaps and credit derivative contract.

Payment Time Period

  1. Average collection period: This is the approximate time being taken by an organization for the purpose of receiving funds on account of accounts receivables. It provides information about the average number of days being taken by the organization to obtain the funds. An organization has an average receivable balance of $20000. Total net sales of the organization are $200000. Therefore, average net receivable for the organization would be at the level of 36.5 days. Therefore, the organization would take 36 days for the purpose of receiving the amount on account of the credit sale. The formula for calculation of average collection period is accounts receivable * days/credit sales.
  2. Account receivable turnover: The average collection period is being related to accounts receivable turnover. This is being calculated by dividing total net sales of the organization with an average of accounts receivables. The accounts receivables for the organization on the basis of the previous turnover would be at the level of 10 times. If there is lower accounts receivable turnover then, it is going to be easier for the organization to make sure that, it is working well in the area of doing the tasks at a particular point of time.
  3. Early Payment Discount Terms

            An early payment discount is being offered by certain companies for encouraging credit customers to make payment for the products at an earlier date. There are situations wherein, an organization offers a discount of certain percentage to the customers at the time when the payment is being made within the due date. A customer would be saving percentage of amount earlier by way of making of the payment in a proper way. 

Discount Payment Terms

  1. Accumulation discount
  2. Disability discount
  3. Military discount
  4. Educational discount
  5. Employee discount
  6. Discount card 

            There is a particular formula which is being used for the purpose of identifying the effective rate of interest being required to be paid by the organization in the course of early payment of money regarding the discounts being offered. 

  1. The difference in payment date opting for early payment and the date on which normal payment is to be made is required to be identified.
  2. The discount percentage is being subtracted from 100% and the result is being divided by discount percentage
  3. The result of step 1 and step 2 are being multiplied together by obtaining annualized interest rate.




Penalty when late payments are made

            When the buyer does not have money for the purpose of making payment for the products then, he would be liable for the purpose of making payment of penalties. The penalties are being identified by way of inflation and interest rates in the country. There are different policies being followed by different countries. In the United States of America, there is a separate law regarding penal rates of interest. It is being calculated on the basis of a balance of receivables due including taxes. The late penalties are required to be shown in sales conditions and business contracts. 

Credit terms Table

            The following table provides information regarding a number of standard payment terms, the meanings and the annual interest rates being charged in the course of the payment terms being taken into consideration.


Credit Terms



Explanation



Effective Interest Rate



Net 10



Pay in 10 days



None



Net 30



Pay in 30 days



None



Net EOM 10



Pay within 10 days of month end



None



1/10 Net 30



Take 1% discount if pay in 10 days, otherwise pay in 30 days



18.2%



2/10 Net 30



Take 2% discount if pay in 10 days, otherwise pay in 30 days



36.7%



1/10 Net 60



Take 1% discount if pay in 10 days, otherwise pay in 60 days



7.3%



2/10 Net 60



Take 2% discount if pay in 10 days, otherwise pay in 60 days



14.7%



Accounting for Credit Terms

            When a customer makes a selection of making early payment and obtaining a discount for the same then, the following accounting entries would be made in the course of the transaction being carried out.


Date

Particulars

Debit (Dr.)

Credit (Cr.)

1 Oct 2016

Cash for the amount received (Dr.)

 Xxx

 

 

Sale discounts for the amount of early payment discount (Dr.)

 XXXX

 

 

Accounts receivable for the full amount of credit sale or invoice (Cr.)

 

xxxx


Types of Accounting Credit Terms


Consolidation loans Lien

S.No.

Terms

Definition

1

Accrued interest

Interest which has been accumulated since the last payment date.

2

Amortization

This is a reduction in the value of the asset in a normal period of time.

3

Balloon payment

It is the final payment of a debt which is larger in comparison to standard payments.

.4

Bankruptcy

When a person is not being left with any money for making payment to creditors.

5

Compound interest

It is a method wherein, interest is being calculated on the principal amount

6

is the loan this combination of obligations for the achievement of smaller monthly payments.

7

Consumer credit

This is the credit which is being extended to personal, family, and household expenses.

8

Credit bureau

This is a kind of form which works towards the maintenance of credit reports of customers.

9

Credit rating

This involves the evolution of credit history of an organization for determining whether the firm is being worthy of obtaining an additional line of credit or not.

10

Fixed interest loan

This is a loan wherein, the interest rate is being determined and it remains the same.

11

Credit rating

This is the evaluation of business of a firm for ensuring that, the creditworthiness of the organization is being identified.

12

Interest

This is the amount which is being charged on the money being obtained as a loan

13

Judgment

An order of court wherein, a person has to make payment of money or carry out surrender of property to another.

14

It i, the claim that the credit or other party has towards the loan.

15

The line of credit

Amount of credit which is being provided by a financial institution at a specified period of time.

16

Mortgage

This is a kind of debt which the borrower gives a lender

17

Net worth

It is the total value of assets of an organization reduced by the liabilities which arise to the person.

18

Overdraft

It is the deficit in the bank statement which is being caused as a result of with the awal of more money from the bank.

19

Lease

This arises at the time when, working capital is being on rent for a period of time.

20

Promissory note

It is a written promise to make payment of a particular amount of money to a particular person.

21

Repossess

This occurs at the time when the property is being seized at the point when the person is not being able to make payment

22

Revolving credit

This is a kind of account wherein, credit purchases can be made by the organization.

23

Right to redeem

This is a right wherein, a customer can buyback his redeemed property

24

Secured credit card

This is a kind of credit card wherein, collateral security is also being taken by the banks for covering the purchase being made on the card.

25

Acceptance date

It is the date on which letter of offer is being accepted by the customer

26

Account controller

This is an individual who is being assigned the duty for maintenance of end to end relationship and account management.

27

Bad debt

When an amount given to any other person is not being recovered

28

Capital

This is the total of assets and shareholders’ funds

29

Collection costs

These are the external costs which are being incurred by HFC for recovery of debts.

30

Credit principles

These are the fundamental code of credit which are being related to business activities across a network.

31

Credit procedures

These are the procedures by which various policies are being followed

32

Extraordinary items

These include the items which are not being related to the business.

33

Intangible assets

These are the assets which do not have any physical existence

34

Investments

These are the assets which are not being used by the organization in the normal course of business.

35

Liquidity

It is the ability of the firm to make the conversion of non-cash assets quickly

36

Reserves

These are the funds of shareholders of the organization. These are the kinds of funds which are categorized as capital and revenue reserves

37

Share capital

It is the total value of shares actually being paid by the shareholders.

38

Working capital

This is the excess of current assets over current liabilities.


Credit Analysis

            Credit analysis is a method which is being used for the purpose of finding out creditworthiness of a particular business. This is a method with which it is being possible to identify whether the financial obligations of a particular business are to be honored or not. The objective of credit analysis is to identify whether both lending and borrowing activities are being carried out appropriately by the organization or not. The risks in rating are being identified and accordingly, decisions are being taken in the course of the accounting decisions which are required to be made.