What are the credit terms of the business?

Definition of Credit Terms

Credit terms refer to the conditions agreed between the buyer and the seller as a part of the agreement regarding the payment for the goods and services transferred. The terms provide for the timing within which the buyer shall make the payment to the seller and any other condition related to such a credit period extended.

Explanation

Companies usually enter into agreements with their customers and vendors. Depending on the credit policy agreed with the other party, credit terms are defined in the agreement. These terms set the time limit as per which payments are to be made. The terms also provide details about the consequences that would arise if the payment is not made within the said time, such as penalty.Further, in order to encourage early payments, conditions may also be prescribed for an early payment discount. The credit period that is agreed between the parties can vary like 30 days, 60 days, etc.

Example of Credit Terms

The credit terms agreed between the buyer and seller as described as follows:

“Term 3/10 net 30”

This implies that the credit period extended by the seller to the buyer is “30 days”. Further, if the payment is done within a period of “10 days”, then a discount @ “3%” is to be allowed to the buyer.

Types of Credit Terms

You can find the following types of credit terms in the agreements:

• Net 10
• Net 30
• Net 60
• Net 90, and so on.

Further, the terms may also provide for discounts if the payment is made within a given number of days, such as “Term 3/10 30”.

Credit Terms and Conditions

Credit terms and conditions include the following elements:

• Credit Period: The credit period represents the maximum time period allowed to the buyer for making the payment such as 30 days, 45 days, 60 days, and so on.
• Credit Limit Allowed: There might be a monthly or an overall limit on the amount of credit that can be availed by the buyer. The same needs to be specified.
• Cash Discount Terms: The credit terms may provide for discounts if the payment is made within a prescribed period of time, which shall be before the last day of the credit period.
• Default Terms: The agreement may provide for the consequences that would be there if the payment is not made within the credit period allowed. The default of payment may result in interest, penalty, or termination of the contract itself.

Factors Influencing Credit Terms

The credit terms that the parties agree, usually depend on the following factors:

• Product Life: The credit period depends on the life of the product. Usually, a longer product cycle means longer the credit period and vice versa.
• Buyer’s Creditworthiness: The seller evaluates the buyer’s ability to make the payments before granting any credit in case of a new customer. For an existing customer, the past experience plays an important role.
• Sellers’s Position: A seller decides the facilities that it agrees to provide in the credit terms. Its negotiating power regarding the terms depends on its market position.
• Level of Competition: The credit terms of the competitors also influence the credit terms offered by the seller. The seller tries to provide better credit terms to attract more customers.

Credit Term Table

The credit terms table of the seller will look as below:

More columns can be added based on the seller’s policy.

Accounting for Credit Terms

The accounting for the credit terms shall be as follows in the books of the seller:

• The amount due from the creditor on account of sale of goods or services shall be recorded as a trade receivable and the credit sale shall be booked as an income.
• If the creditor makes the payment early due to which cash discount is allowed, then such a discount allowed shall be booked as an expense.
• If the credit doesn’t make the payment and penalty or other charges are levied, the same shall be booked as an income. However, the need for making a provision for bad debts shall also be analyzed.

Advantages

The advantages of credit terms are as follows:

• Extending a credit facility to the buyer enhances the business and the growth of the seller.
• There is effective usage of the funds by the buyer and he gets to enjoy the credit period.
• The system serves as an alternative to the cash system.

Disadvantages

There are certain limitations with respect to the credit terms:

• There is credit risk to the seller that the payments might not be received on time or at all.
• Sometimes, credit facility comes at additional costs and buying the same product can be less costly when made in cash.

Tips for Credit Terms

Here are some tips that one may follow for credit terms.

• The seller should ensure about the creditworthiness of the buyer before extending any credit limit.
• The seller shall review whether the payments are being received on time or there is a need to revise the credit limit.
• The buyer shall make sure to utilize the maximum credit limit for its advantage.

Conclusion

Credit limits decide the terms of payments between the seller and the buyer. The terms are advancing with time and businesses are finding new ways to provide the best to their customers. However, one must ensure the creditworthiness of the other party before extending any credit.

Recommended Articles

This is a guide to Credit Terms. Here we also discuss the definition and types of credit terms along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Revolving Credit Facility
2. Debit Note vs Credit Note
3. Adjusting Entries
4. Creditor vs Debtor
5. Assets List