Accounting Business Reporting for Decision Making

542 Accounting: Business Reporting for Decision Making

Trade credit

Trade credit is possibly the most important source of short-term finance for entities. This is because such

credit arises during the normal course of business and is normally extended without formal agreements.

Moreover, trade credit is normally unsecured and requires nothing additional to normal accounting prac-

tices for its successful management. Trade credit these days is most likely to be offered on a net 30-days

or even net 7-days basis. This means that the full amount of the invoice must be paid within 30 days or

7 days. Often, where a customer makes many purchases within the monthly accounting period, a state-

ment of account is sent out to the customer at the end of the month, and then the customer has 30 days

in which to pay the whole amount.

The management of trade credit should be built into an entity’s accounting systems and processes.

For example, an entity might have an internal rule that one week’s invoices are batched on Fridays (or

any other selected day) and paid on the third Friday following the batch day. This means that no invoice

would remain unpaid for longer than 30 days. Such a system allows a measure of control. An alternative

system that exhibits control but is extremely costly in terms of both labour costs and the opportunity cost

of cash — and so is not favoured by large entities — is to pay all invoices upon receipt.

Because managers need to monitor this function of their businesses, they need a single measure

that gives them information about how their businesses (and office processes) are performing. Such a

measure is the creditors turnover. Illustrative example 13.1 demonstrates how this measure is calculated

for Turner Ltd.

Creditors turnover =

Average trade creditors × 365

= x days

Credit purchases

ILLUSTRATIVE EXAMPLE 13.1

Calculating the creditors turnover

During the last five years, Turner Ltd had the following trade creditors at balance date and made the

following credit purchases (in $ million):

Item 2011 2012 2013 2014 2015

Trade creditors 400 416 436 468 556

Credit purchases 3 660 3 940 4 220 4 710 5 658

What is the trend in average settlement period?

First, we must find the average trade creditors value for each available year. These are the last four

years, as we do not have the information to compute average creditors for 2011. The average for 2012

is 408 [(400 + 416)/2] and, for the following three years, 426, 452 and 512 respectively. We can now

substitute into the equation and compute the average settlement periods for the four years, as follows:

Item 2011 2012 2013 2014 2015

Average trade creditors na 408 426 452 512

Credit purchases na 3 940 4 220 4 710 5 658

Creditors turnover (days) na 37.8 36.8 35.0 33.3

From these data, it is apparent that Turner Ltd keeps strict control of trade creditors (average of

35 days) and has put effort into bringing the average settlement period down. Entities that do not have

adequate control over their creditors face interest on overdue accounts and the possibility of losing the

trade creditor as a major supplier of their product or service to the entity.