Question

5.2.1 Suggest FOUR (4) strategies that a business entity may use to manage trade credit effectively
5.2.2 Explain the consequences of abusing trade credit terms offered by suppliers
5.2.3 Discuss the reasons why businesses use Trade Credit when purchasing from suppliers (5
marks)

Answer 1

5.2.1 Suggest FOUR (4) strategies that a business entity may use to manage trade credit effectively

Cash flow is the very lifeblood of a business. In this regard, each business should consider whether it is doing everything it can to ensure that its customers are paying on time. Furthermore, the recovery of business debt can be frustrating, time consuming and often unsuccessful. It is better to put in place proper procedures, which enable the early identification of potential bad debts.

1. Have a credit policy and terms of trade in place

Many businesses supply goods and services on the basis of informal arrangements. Unfortunately this means that disputes often arise that could have been avoided if there had been clear, written terms of trade from the start. Having clear terms of trade is an excellent way of minimising and preventing bad debts.
Make sure you complete thorough credit history and business reference checks before you offer credit to new customers. Clearly articulate to your customers up front, in writing, your terms and the credit limits (so they know you are serious about your collection program) and ensure that they sign acceptance of your terms. It’s important that all your staff understand and follow this credit policy.

If you decide to implement new payment terms and conditions, begin with new customers or customers who wish to extend their credit limit. You may find it more difficult to introduce new terms to existing customers, especially those who have been loyal in the past or who you know personally and don’t wish to upset!

2. Provide the right information on quotes, invoices and statements

If you provide the right information on your documents, and invoice promptly, you are more likely to be paid on time.

All quotes, estimates, invoices, contracts, agreements, purchase orders, and related documents should refer to your terms of trade and credit policy. Invoices and statements should show clearly:

• the amount owed
• the payment due date
• the billing address

Include any extra details that a customer might need, such as the purchase order number, contract/account number, and details of who placed the order. If necessary, contact the customer before billing to check exactly what information they need to expedite payment.

A good way to discourage late payment is to show details on your invoices and statements of the collection charges you may apply to overdue accounts.

3. Make sure your systems are up to date and monitored

The secret to good debtor management is well-maintained information. There are many software solutions available to help you with your credit management, and increasingly more of them are cloud-based. Good software solutions can relieve you of much of the administrative and management pain associated with debtor management.

The best way to minimise issues is to monitor your debtors ledger closely – by keeping close track of the days outstanding you’ll be able to spot adverse trends and take prompt action before they start to have an impact on your cash flow.

4. Implement robust accounts receivable processes

It is very important to have a robust collections process in place, with set timescales for the various stages of communication (letters, emails and phone calls). Map out your process clearly and make sure it’s understood by all your staff. Here are some key points to consider:

Check your delivery systems and keep signed delivery dockets so that you can prove delivery.

• Invoice as early and as often as possible, as receiving invoices late encourages customers to delay payment.
• Automatically send 30, 60, and 90 day reminder letters and highlight your trade terms where these are not being met.
• Regularly follow up on all slow payers to encourage payment. Once customers know you will always make contact if payment is late, you are more likely to get priority when they schedule payments. Don’t finish a follow up call without obtaining a firm commitment to make a payment. Follow up again if it is not paid on the promised date – or better still, arrange a visit.

5.2.2 Explain the consequences of abusing trade credit terms offered by suppliers

Negative Effect on Cash Flow

The most immediate effect of trade credit is that sellers do not receive cash immediately for sales. Sellers have their own bills to pay and extending credit terms to buyers creates a hole in their companies' cash flow.

Must Investigate Creditworthiness of Customers

Just like a bank, a vendor who extends credit to customers needs to analyze their credit ratings. This takes money and time. Obtaining business credit reports, such as Dun & Bradstreet, cost money, and making calls to check on references takes time. A vendor may need to hire an additional person who has credit analysis skills to help make the decisions about extending terms of payment.

Monitoring Accounts Receivable

Extending credit creates more outstanding accounts receivable, and someone needs to monitor these customers to make sure that they are paying on time. A company that is making its sales in cash does not have this problem.

Financing Accounts Receivable

The extension of credit terms to buyers means that the seller has to finance these receivables. A seller may have to lean on his own suppliers to receive trade credit, borrow on his bank line of credit or use the company's accumulated retained earnings. All of these methods have an inherent cost of capital.

Possibility of Bad Debts

Inevitably, the extension of trade credit will lead to some buyers not paying their debts. When this happens, an employee needs to spend time making collection calls to the late payers, and, eventually, the seller may need to write off the unpaid receivables and take a loss.

Extending credit terms to buyers is common in most industries. Businesses must offer some level of extended payments to be competitive in their markets. However, offering credit terms requires taking risks and spending additional time monitoring and collecting accounts receivable.

5.2.3 Discuss the reasons why businesses use Trade Credit when purchasing from suppliers

Help startup businesses get up-and-running – Trade credit can be useful for new businesses unable to raise funding or secure business loans, yet need stock quickly. However small businesses can be hamstrung by a lack of trading history which makes obtaining trade credit difficult.

Get a competitive edge – Buying goods as required on credit gives businesses a competitive advantage over rival firms that may have to pay upfront. Using trade credit allows your business to be more flexible, adapting to market demands and seasonal variations so that you have a constant supply of goods even when your finances aren’t stable.

No cash required upfront – With no need to pay cash up front, buyers can stock up in time for peak demand, such as placing bigger orders to take advantage of key seasonal selling times such as Christmas. Trade credit is an advantage as cash flow may be low coming off quieter months, potentially preventing enough stock to be purchased for peak selling times.

Fuels business growth – Think of trade credit as an interest-free loan. It’s one of the best ways to keep cash in your business, effectively providing access to working capital at no cost. There’s less administration compared to arranging a short-term loan. Instead, rather than using cash reserves on stock, your business is effectively selling goods on behalf of the supplier and getting a profit for doing so.

Easy to arrange – If your business has a good credit history, is able to meet a supplier’s requirements and has the ability to make regular payments then trade credit agreements are typically easy to arrange and maintain. There are few formal arrangements or negotiations to complete, making it quick-&-easy to use.

Increases your company’s reputation – Demonstrating your business can make regular payments against credit is a good way of establishing and maintaining your company as a valuable customer. A good trade credit history can mean suppliers treat you as a preferred buyer.