The importance of trade terms

Most businesses need to sell on credit to maintain a solid customer base. Managing debtors and cash flow is an important part of running a business well. Therefore, it is essential to establish a credit policy that identifies the people and businesses you are willing to give credit to, the amount of credit to be given, and terms and conditions of trade.

On this page:

• How does trade credit work?
• Credit applications and terms of trade
• Other benefits of credit applications

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How does trade credit work?

Trade credit may either be long term or short term. A seller typically extends trade credit to a buyer, offering the buyer a specified time to pay for the goods.

Trade credit may be offered on net terms, which means that no interest will be charged if payment is made within the specified period, which is usually from the invoice to the 20th of the following month, or 30, 60, 90 or 120 days. The actual credit terms of trade credit appear standardised within industries, although they may vary from industry to industry. They tend to remain constant and not be affected by supply and demand.

In addition to providing sellers with information on the creditworthiness of customers, trade credit offers can serve to bond relationships between buyers and sellers. Sellers who offer trade credit generally have a financial interest in maintaining a continuing relationship with their buyers. The extending of trade credit also gives the purchaser time to verify the quality of the goods purchased and evaluate the seller’s performance.

Financially, the handling of trade credit offers and payments are part of a business’s accounts receivable and accounts payable. Simply being able to withhold payment for 30 to 120 days without paying interest improves the purchaser’s cost of funds and provides greater control over cash flow.

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Credit applications and terms of trade

The credit application form is the first point of contact between your organisation and a potential customer, and formalises the relationship and the basis on which it is going to exist. However, if the application seems overwhelming to a potential customer, they might instead go to a business where credit is easier to obtain. Hence, it is important to achieve a balance between the need to obtain information to make an informed credit decision, the importance of having the relationship in writing, and the need to generate revenue.

There are a number of reasons why having terms of trade makes good business sense. A credit policy is generally accepted commercial practise and it is common practise to complete a credit application form. A credit application with terms of trade forms a sound credit control system that reduces the risk of incurring bad debts. It also enables you to:

• identify your customer and maintain customer records.
• undertake applicant screening with a Commercial Bureau to determine the risk involved when assessing credit risk.
• use applicant screening to identify the need for additional security and/or set credit limits.

The credit application with correct terms of trade is required to meet legal requirements, including but not limited to: the obligation to obtain your client’s consent regarding collection, defaults, and review of an individual’s credit information under the Privacy Act; along with requirements on charging interest, maximum credit limit, and the disclosure of registering security interests. Every industry is different and terms of trade should reflect particular industry requirements. The terms of trade create a legally binding contract.

Terms of trade eliminate any misunderstanding about the relationship, thereby allowing both parties to make an informed credit decision.

Most major lending organisations, including banks, credit card, finance, telecommunications, and utilities companies, and trade suppliers of credit, use the credit application form as the means to gather information on which they will base a decision. When applying for credit, most potential customers would expect to complete a credit application form that contains terms and conditions of trade.

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Other benefits of credit applications

While the credit application does not determine risk, it provides information that can be verified and validated in conjunction with other data, such as credit reports with trade payments, to reach an informed decision. This type of background check provides a position from which an application for credit can be benchmarked.
Identifying whether additional security is required to protect your interests as a creditor is considered more important than making a security official. Getting written agreement on some securities, such as a personal guarantee, is getting harder to obtain. Information on the credit application form with terms of trade assists credit personnel in making a decision on the requirement for additional securities.

A sound and properly administered credit policy, together with rigorous control over debtors, will do much to improve cash flow, and reduce both the level of bad debts and the time and expenses of debt recovery procedures.

A set of standard terms of trade could be used but these would not take into account the strategic direction and values of an organisation, nor would they acknowledge that different levels of risk are appropriate for different industries and the organisations that work within these industries. While it may seem easy to design terms of trade, there are a number of legal considerations involved.

Because of the complexities involved in developing appropriate terms of trade, it should be done with professional assistance. When your terms of trade are required for effective collection recovery, you will realise their value.
 

• This information is provided by Veda Advantage
   
  www.vedaadvantage.com