Credit terms are terms which govern a credit sale. They represent an arrangement between a buyer and a seller regarding the expected payment date, any discount offered and the period in which discount is available.
Credit terms are expressed as x/y, net z where x is the percentage discount that is offered, y is the number of days in which the discount can be availed and z is the credit period.
It is important for a business to understand and follow the credit terms because failing to meet them may lead to penalties and poor credit history. Businesses calculate the cost of foregoing trade credit and compare it with their cost of capital. If the cost of foregoing trade credit is higher than the cost of capital, it is financially beneficial for them to avail the discount.
Kohli Fibers provides artificial fibers on credit to Jadeja Textiles. On 1 December 2012, 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 2012. However, if Jadeja Textiles can manage to pay within 10 days of the sale i.e. by 11 December 2012, it will receive a discount equal to 2% of the sales value.
Written by Obaidullah Jan, ACA, CFA