Page 166 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 10: Receivable Management

10.1 Objectives of Trade Credit Notes

Trade credit exists when one firm provides goods or services to a customer with an agreement to
bill them later, or receive a shipment or service from a supplier under an agreement to pay them
later. It can be viewed as an essential element of capitalization in an operating business because it
can reduce the required capital investment to operate the business if it is managed properly.

1. To reduce capital requirements: If a firm has trade credit arrangements with its suppliers, it’ll
obviously require less capital to operate the business. It can make payments to its suppliers
within the decided credit term, upon receipt of payment from its customers. Thus, the
business will continue to operate with lower capital requirements. Additionally, firms can
then effectively leverage the capital towards activities such as acquiring new customers,
enter newer markets, engage in product research to produce better products, etc.
2. To improve cash flows: Simply defined, cash flow is the amount of money coming into a
business in comparison with the amount of money going out. A positive cash flow
(i.e. amount of money coming in greater than that going out) enables a smoother business
operation. With trade credit, businesses can buy now and pay later – thus postponing the
amount of money going out. Payments can be deferred as defined in the credit term and
can be made on receipt from customers.

3. To help increase business focus: With a trade credit agreement in place with suppliers,
businesses can look to grow without the burden of immediate payments setting them
back. Business growth requires investment – growth could be hampered if most of a
business’ capital is spent in making payments. As mentioned in the paragraph above, with
trade credit, businesses can focus on activities like sales and marketing, research and new
product development to further acquire new customers and enter new markets.

Notes Trade credit creates a win-win proposition for both – buyers and suppliers. While
buyers have the advantages as accruing from the points discussed above, suppliers also
have assured buyers for their products.

Self Assessment

Fill in the blanks:

1. ........................... exists when one firm provides goods or services to a customer with an
agreement to bill them later.
2. If a firm has trade credit arrangements with its suppliers, it’ll require ...........................
capital to operate the business.

10.2 Credit Policies

A firm’s credit policy is regarding its credit standards, credit period, cash discounts, and collection
procedures.

10.2.1 Types of Credit Policy

The credit policy may be:
1. Lenient or
2. Stringent (tight)

LOVELY PROFESSIONAL UNIVERSITY 161