Credit terms (also known as terms of payment) are terms and conditions which govern a credit sale. They stipulate an arrangement between a buyer and a seller regarding the payment date, any discount offered, the period in which the discount is available and any additional requirements.
In addition to being verbosely detailed in the contract of sale, credit terms regarding payment dates are usually expressed in a short form to facilitate communication. The short form typically used is "X/Y, net Z", where:
- X is the percentage of cash discount that is offered,
- Y is the number of days in which the cash discount can be availed, and
- Z is the credit period.
For example, credit terms stated shortly as "2/10, net 30" mean that the payment is due in 30 days, and that a cash discount of 2% is available if the payment is made with in 10 days.
Where no cash discount is offered, credit terms are shortly stated without "X/Y" figures in the above format. So credit terms for a credit sale where the payment is required in 30 days but no cash discount is offered, will be stated as "net 30" or simply "n/30".
It is important for a business to understand and follow the credit terms because failing to meet them may lead to penalties or may result in a poor credit score.
Businesses calculate the cost of foregoing trade credit (i.e. availing the cash discount) and compare it with their cost of capital. If the cost of foregoing trade credit (and obtaining the cash discount) is higher than the cost of capital, it is financially beneficial for them to avail the discount. If this is not the case, the payment should be delayed as much as the date allowed in the credit terms.
Kohli Fibers provides artificial fibers on credit to Jadeja Textiles. On 1 December 20X2, it made a sale of INR 20 million with credit terms of 2/10, net 30.
This means that Jadeja Textiles can pay Kohli Fibers within 30 days i.e. by 31 December 20X2. However, if Jadeja Textiles can manage to pay within 10 days of the sale i.e. by 11 December 20X2, it will receive a discount equal to 2% of the sales value.