Credit terms are the conditions under which credit will be extended by a lender to a borrower. These terms specify the repayment period, any interest or service charge, and the discount for prompt or early payment, if any. They form a part of the terms and conditions of a sales or loan contract.
In the context of sales, credit terms are often stated in the format “X/Y, net Z.” Here’s what this means:
- X: The percentage discount that the buyer can take if they pay within the specified discount period.
- Y: The length of the discount period, typically stated in days.
- net Z: The full (net) amount of the invoice is due within this number of days.
For example, credit terms of “2/10, net 30” mean that the buyer can take a 2% discount if they pay within 10 days; otherwise, the full amount is due within 30 days.
Credit terms will vary based on various factors such as the nature of the product, market practice, the relationship between the seller and the buyer, and the buyer’s creditworthiness. Offering credit terms can help sellers attract more customers, but it also exposes them to the risk of delayed or non-payment. Therefore, sellers must carefully manage their credit policies and procedures.
Example of Credit Terms
Let’s take an example of a business transaction.
Suppose a furniture manufacturer, “QualityFurniture,” sells $10,000 worth of chairs to a retailer, “HomeDecor.” The credit terms are “2/10, net 30.”
Here’s what these terms mean:
- 2/10: HomeDecor can take a 2% discount, or $200, if they pay within 10 days. So, if HomeDecor pays within this period, they would only need to pay $9,800.
- net 30: If HomeDecor doesn’t take advantage of the early payment discount, the full amount of $10,000 is due within 30 days of the invoice date.
So, if HomeDecor pays within 10 days, they get a discount and pay less. If they pay later (but within 30 days), they pay the full invoice amount. If they fail to pay within 30 days, they might incur late payment penalties or damage their credit relationship with QualityFurniture, which could affect future transactions.
This is a simplified example, but it illustrates how credit terms work in a typical business-to-business transaction.