Basic Mechanics of Credit Management

Credit Terminology

Credit terminology can be extremely confusing, and terms differ from industry to industry. It is therefore difficult to define exactly how a set of credit terms should be interpreted. Even experienced individuals in one industry become confused when quoted terms in another. When in doubt, ask for clarification.

In the current practice of selling on “open account”, as opposed to the practice years ago of taking a customer’s note when a sale was made, the seller states when payment is due. The customer, by entering into the transaction, accepts these terms. Typical payment terms are 30, 60, and 90 days after the date of the invoice.

The seller also often offers its customers a discount for prompt payment. A common discount is 2 percent on bills paid within ten days of the invoice date, with payment due within 30 days in any event. These terms might read: “2/10, net 30.” Another form provides for payment to be made within ten days after the end of the month in which the invoice is rendered. These terms might be stated: “10 days EOM” or “10EOM.” If a discount is also offered, it could read “2/10 EOM”. “Proximo” is another term to designate the month following the invoice date — “10 prox.” is the same as “10EOM.”

For example, in some industries a wholesaler or distributor is billed at the price the wholesaler is expected to charge the retailer for the merchandise. The wholesaler is given a distribution discount as well as a prompt-payment incentive. For instance, suppose a manufacturer sells both to retailers and wholesalers. The retail terms are “2/10, net 30.”The manufacturer bills the wholesalers at the same price charged the retailers, but wholesalers are also allowed 8 percent for their distribution services. This set of wholesale terms might read:”8/2/10, net 30.”Whether the 8 percent is deducted before the 2 percent is taken is peculiar to each industry. In volume, of course, it makes a substantial difference if total discounts are 10 percent of the invoice or only 9.84 percent.

Cost of granting discounts:

The cost of granting discounts for prompt payment can be considerable, and the cost of failing to take those terms can be equally expensive.

If a company forgoes a 2 percent discount, delaying payment from the 10th to the 30th day, it has lost 2.04 percent of the net cost to gain 20 days extra credit. There are approximately 18 2(May periods in a year. At slightly more than 2 percent for each period, the annual rate is about 37 percent.

Stated another way, if the firm borrowed from its bank at a 10 percent annual rate, the cost per day would be 10 percent -360, or .028 percent a day. For 20 days, this would amount to 0.56 percent. By failing to make prompt payment, the firm is giving up 2.04 percent for a net cost of 1.48 percent (2.04 — 0.56) for 20 days or over 25 percent a year.

Granting credit discounts is equally costly to the supplier that can afford to borrow at low rates to support its accounts receivable but whose customers take their discounts. The customer makes 25 percent a year by paying promptly. The supplier loses a comparable amount by granting the discount terms rather than simply collecting on the 30th day.

The supplier is often motivated in extending credit by considerations other than interest rates. Credit terms are often used as aggressive competitive tools, providing better customers with disguised discounts in much less obvious form than direct price cutting. The better-financed customers have a clear advantage on this score because of their ability to take discounts. Similarly, better-financed suppliers can offer more generous terms that less well-financed competition may not meet.