Select Your Location
Trade credit works as a quite
effective mode of financing variable working capital for a business entity for
the period falling between the point goods, raw materials, etc. are purchased
from the suppliers and the point when payment is made. The longer this period,
the more advantageous it becomes for the organisation to avoid efforts of
seeking finance for holding inventories or receivables. Similarly, it should be
borne in mind that payment to trade creditors, domestic and overseas, has to be
made within the stipulated period of time for avoiding interest payments,
penalties, etc. Trade credit received by businesses on purchases reduces the
working capital fund requirements and has to be taken into account for a correct
assessment of funds.
There is a prolonged belief in
business, trade and industrial world that if you can buy well, then you can
sell well. The management of your suppliers and creditors is just as crucial as
the management of your customers and debtors.
Trade creditors represent a
spontaneous source of short-term finance in the sense that they arise from the
course of ordinary business transactions. But it is important for businesses to
diligently to look after their creditors. The main reason being, slow and
sluggish payments by a business enterprise may create ill-feeling amongst
creditors, which may even cause the supplies to be disrupted. Such delay in
payments could also create a bad image for the company. In addition, creditors
form a vital part of effective cash management and should be managed carefully
to enhance an entity’s cash position.
A sound management policy to plan and control the accounts payables or trade credit in a business organisation is imperative due to the following reasons:
It is usually conceived by
people that the trade credit does not carry any cost. However, this is not true,
and trade credit carries the following costs:
Not only does trade credit
come with some implicit costs, but it offers many benefits to business firms
also. In fact, it is considered as one of the most effective sources of
obtaining short-term finance by business entities. The benefits offered by
trade credit or the cost of not taking trade credit cover the following:
Read, Also: 8 Key Performance Metrics for Accounts Payable Processes.
It is extremely important to
analyse the benefits offered by the suppliers via credit extension on the one
hand and the cost involved in taking the credit extension provided by suppliers
(i.e., the cost of discount foregone) on the other hand. In simple words, a
risk-return trade-off has to be put into due consideration before accepting
credit offers or discount offers by suppliers. There has to be judicious use of
trade credit by a business in order to maximise its returns.
Suppose a company has been offered credit terms from its major supplier of “2/10, net 45”. The amount of the purchase invoice is Rs. 20,000. Hence, the company has the choice of paying Rs. 20,000 at 45th day by accepting trade credit or else paying Rs. 19,600 at the 10th day by accepting the discount offer. With the first option, the company can invest Rs. 19,600 for an additional 35 days and eventually pay the supplier Rs. 20,000 at the end of 45 days. The decision as to whether the discount should be accepted or not depends on the opportunity cost of investing Rs. 19,600 for 35 days. The company can invest additional cash and can obtain an annual return of 25%.
For analysing the cost of payables, the two alternatives, in this case, are as follows:
Thus, it is better for the
company to refuse the discount, as return on cash retained is more than the
saving on account of the discount. Had the annual rate of return on investment
been 20%, it would have been more favourable to accept the discount offer of
2%. In that case, the net cost payable would have been Rs. 19,624.
Another aspect to consider here is calculating the annualised cost of taking credit, i.e., the cost of not taking the discount and delaying the payment for a term of 35 days. Such annualised cost of trade credit is computed with the help of below formula:
The company can compare its
cost of funds or short-term investment rate with the cost of trade credit to
make a decision regarding availing the discount. Generally, in most cases, if
the cost of funds or short-term investment rate is lower than the cost of trade
credit, then the company will benefit by paying its invoices within the
On the other hand, if the
business could borrow at a rate which is less than the annualised cost of trade
credit, then it would be preferable to do so and take the early payment
discount offered by the supplier.
In the example given above,
the cost of trade credit comes out to 23.45%, with discount% = 0.02 and Days
after discount period = 35. Thus, when the company delays suppliers’ payment,
it incurs an annualized cost of 23.45% per annum. Now, let’s assume that the
company can borrow a bank overdraft at an interest rate of 18% p.a.; here it
would be preferable for the company to borrow money from bank instead of
availing the supplier’s credit.
Some of the techniques which
may be employed by the finance manager for effective management of accounts
Timing of payments is crucial: When it comes to the optimization of working capital, increasing payables should be a main strategy. To ensure this, many organisations follow this strategy by extending payables as long as possible in order to maximize free cash flow. But, this approach is not always the correct one. In some instances, delaying payments can erode suppliers’ confidence/trust, resulting in slower delivery times, less willingness to fix defects, slower responses to address post-purchase queries and more troublesome payment terms. On the other hand, paying early can often yield substantial benefits in situations where suppliers offer bulk discounts or rebates for making an early payment.
the Invoicing and Reporting Process: To improve liquidity, properly managing
the invoicing process is essential. This involves setting up a centralized
processing office, processing invoices on a timely basis and including a date
stamp, etc. To boost accounting and reporting process for proper management of
payables, companies must apply payments to every invoice on the date they are
made to assure system accuracy, post journal entries before cut-off dates of the
reporting period, and follow up on and resolve un-reconciled items on a timely
Invoice to Purchase Order Matching: Before issuing payments, companies must confirm if order
deliveries tally contractual terms by accessing vendor contracts. Purchase
orders should be issued for every fresh order so that the company can validate
any orders received, lock in payment terms well in advance and track invoices
against current purchase orders to ensure that vendors are billed in conformity
with agreed-upon terms. Such standards should be adhered to across the
the occurrence of Accounts Payable Errors and Fraud: For the management of payables, it
should be ensured that the risk of manual errors and frauds is minimal by using
automated mechanisms, strengthening internal controls around accounts payable
processing, and accurate contract review.
of accounts payable processes: For effective management of payables, a business should
streamline its accounts payable transactions. These involve the company’s
ability to process bills on a timely basis, take advantage of available
discounts, rely on automated systems to approve purchase requisitions and issue
payments, feed accurate supplier or contract information into master data
files, and set either longer or shorter payment terms with suppliers depending
on which are most favourable. Improving the systems of accounts payable can
help increase the accuracy of cash flow budgets, ultimately positioning the
business to enhance liquidity, reduce funding gaps and realize higher profits.
The accounts payable team of
an entity, together with the material and purchasing departments; should coordinate
with top management to implement a sound payables’ policy or working capital
culture throughout the organisation. It comprises much more than just seeing that
purchase invoices are procured and processed in a timely manner. The overall goal
should be to adopt a management focus that emphasizes the significance of
optimizing payables and freeing up working capital to fuel growth.
Enterslice offers expert Accounts Payables Services to cater to your needs and create a robust framework for the management of payables in your business. We provide help in payment processing, invoicing and reporting procedures, vendor data management and more.
Also, Read: How to Leverage Accounts Payable to Improve Working Capital.
A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.
On 18th May 2023, the Securities Exchange Board of India (SEBI) released a Consultation Paper o...
Infrastructure and real estate have been regarded as India's "sunshine sector" since the turn o...
On 22nd May 2023, the Central Board of Direct Taxes (CBDT) issued a new circular under secti...
Anyone can have different sources of income. With globalization and the opening up of economies...
The Reserve Bank of India (RBI) is crucial in regulating NBFC, including branch openings and cl...
In India, Non-Banking Financial Companies are subject to certain restrictions from taking publi...
It's usually a good idea to diversify the assets in your financial portfolio, especially during...
A nation is being built by the non-banking finance company through the development of wealth, t...
A corporate entity known as a portfolio manager complies with a contract or agreement with the...
Identifying and analysing risks associated with individual portfolio investments, such as equit...
Are you human?: 6 + 1 =
Easy Payment Options Available No Spam. No Sharing. 100% Confidentiality
In every company, the management needs information to arrive at decisions and evaluate the company's performance in...
08 Jul, 2020
Standard of auditing 230 refers to the auditor's purpose in constructing documentation of audit, which gives an ade...
16 Nov, 2022
Red Herring Top 100 Asia enlists outstanding entrepreneurs and promising companies. It selects the award winners from approximately 2000 privately financed companies each year in the Asia. Since 1996, Red Herring has kept tabs on these up-and-comers. Red Herring editors were among the first to recognize that companies such as Google, Facebook, Kakao, Alibaba, Twitter, Rakuten, Salesforce.com, Xiaomi and YouTube would change the way we live and work.
Researchers have found out that organization using new technologies in their accounting and tax have better productivity as compared to those using the traditional methods. Complying with the recent technological trends in the accounting industry, Enterslice was formed to focus on the emerging start up companies and bring innovation in their traditional Chartered Accountants & Legal profession services, disrupt traditional Chartered Accountants practice mechanism & Lawyers.
Stay updated with all the latest legal updates. Just enter your email address and subscribe for free!
Chat on Whatsapp
Hey I'm Suman. Let's Talk!