The mere existence on a company’s balance sheet of accounts receivable or accounts payable is synonymous with commercial credit, whether the company extends credit to its customers (in the first case) or receives credit from suppliers. (In a second).
Extending business credit is more complex than its definition implies. There are multiple purposes, consequences and risks of commercial credit. Offering commercial credit implies delivering a merchandise at risk of default, that is, with credit risk. Which, materializes if the client does not pay, causing losses for the company.
To prevent credit risk from manifesting, you must formulate and apply effective credit policies, analyze the client or potential credit applicant, assess the risk, implement the collection, follow-up of the accounts receivable portfolio, raise provisions. All of which represents procedures, hiring of personnel and especially costs and time invested.
With all this said, a small or medium-sized businessman can choose to simply not grant commercial credit, but he will be one step behind his competitors, being exposed to losing new businesses and progressively yielding his clients to the competition.
A company can experience positive and negative effects, as well as the significant impact of business credit, especially on its finances. We offer you a brief introduction of what commercial credit is and what it represents for companies.
What is commercial credit?
The simple definition of trade credit occurs when a supplier of goods or services will extend credit to a customer and allows you to pay for products at a later date.
In a commercial credit operation, both the supplier and the client agree and recognize payment terms and conditions that involve a payment date and a possible discount for prompt payment, which the client agrees to if he pays sufficiently in advance.
For example a credit sales invoice can bring the condition 2/10 net. 30 which means that the client opts for a 2 percent discount if he cancels within the first ten days of the invoice being issued, which must be paid within the next thirty days after it is issued.
For Some the commercial credit is a means of short – term financing in which providers allow customers to make and receive orders without having to disburse payment immediately.
The commercial credit is a term used to refer to the relationship between a company that provides goods or services using flexible payment terms, and the client that uses these terms to purchase from the supplier.
When a company offers this type of financing, it agrees to receive payment at a later date. The commercial credit is one of the most used sources of funding by US companies, excluding bank loans.
Commercial credit function and importance
The commercial credit can have multiple functions depending on the situation. More commonly, this type of financing has the function of providing a portion of capital for small or growing companies.
In emerging economies, it is common to use commercial credit as collateral for other types of financing, such as money orders and factoring, since this means that there is a source of income to be received if the company is the supplier, or a good record payment if the company is the customer.
Another function of trade credit for business is to finance growth. If used in this way, a company can postpone expenses and increase revenue, and merchandise received on credit can become the source of payment whenever the customer makes his own sale.
The importance of using commercial credit is not only translated in terms of working capital. If used correctly, it can not only provide a useful means of increasing capital, but also as a way to build a business credit history, as timely payments testify to solvency and financial stability.
On the other hand, both the absence of commercial credit and the ineffective use of it can lead to higher operating costs and hinder future credits of different kinds. In this regard, business credit is similar to bank or personal credit, as timely payment improves borrowers’ ability to obtain more credit, while slow or no payment can destroy future business and financial operations.
The commercial credit, when not handled properly, can also affect insurance premiums, bank interest rates and be a sign of financial problems or difficulty of management to run the business.
The cost of not taking advantage of prompt payment discounts
Although business credit can be an important part of working capital, it can also be expensive.
Depending on the terms of the agreement, the discount offered or the expiration date, penalties may be considered if payments are late. There are also discounts for punctual payments to the line of credit.
Most credit sales agreements provide penalties for late payments if a business falls behind on its bills.
To exemplify if your company receives an invoice for USD 1,000 net in 30 days and you do not pay on time, you will be subject to a fine of USD 20. Over the course of a year, this would be equivalent to USD 240 added to the total paid during the year. In other words, 24% annualized, which you could add to 36% for not taking advantage of the discount.