The ability of a business to borrow for a short term depends on its credit, that is, its ability or power to purchase and to repay later. Thus there are two facets to credit. First, the seller or lender must have faith that the buyer will repay, and second, he must be willing to undertake the risk of waiting the specified period before repayment is to take place.
The seller or lender is willing to rely on his faith and to undertake the risk for several possible reasons. A lender such as a bank or other financial institution is anxious to lend if it has idle funds which can be employed to earn interest income. For sellers, extension of credit makes possible the smooth conduct of their business, and is often used as a competitive device.
By far the most common method of short-term financing, often the only major source of credit for the small business, is trade or open-book credit. This means that the buyer establishes credit with a seller, and the seller allows the buyer a specified time, usually thirty, sixty, or ninety days, to pay for goods and services purchased in the normal course of business. The wide use of trade credit in the United States, estimated to involve over 85 per cent of business transactions dealing with inventory, is important both in the smooth conduct and in the growth of business. This type of credit exists at all levels of the production-consumption cycle-between supplier and manufacturer, manufacturer and wholesaler, wholesaler and retailer, retailer and consumer. Credit for the last step, which involves the consumer, is normally referred to as the charge account.
In effect, the seller of goods or services is making a short-term loan to the buyer by allowing him time in which to pay. Although there are patterns, credit terms vary with the stage in the production-consumption cycle, and from industry to industry and company to company. As a rule of thumb, the longer terms of credit are usually allowed at the farthest point from the ultimate consumer, because the length of time before realization is also longer. For example, a supplier of raw materials may allow a manufacturer ninety days, a manufacturer may allow a wholesaler sixty days, a wholesaler may allow a retailer thirty days, and a retailer may expect to be paid by the consumer in one to twenty-five days. In some industries, credit terms are matters of intense competition. In the farm industry, suppliers often give retailers terms of six months or more to allow them to sell to farmers in the spring and collect in the fall when the crops come in.
Sellers frequently offer buyers a discount as an incentive for early payment. For example, a sale may be made with terms 2/10, n/30. This means that the buyer has thirty days to pay the net amount, but if he pays in ten days he will get a 2 per cent discount. It is almost always to his advantage to take the discount even if he has to borrow from other sources, because the saving of 2 per cent for twenty days translates into an annual rate of 36 per cent. The supplier can afford to give such generous terms because if his buyers pay him promptly, he can take advantage of similar discounts from his suppliers.
Second in importance to trade credit as a source of short-term capital are promissory notes payable to firms, individuals, or banks, A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, to pay a definite sum at a fixed date. The maker is the one who signs the note and who must pay at the assigned time. The person, firm, or institution to be paid is the payee. In the note, the maker, Melvin C. Jones, promises to pay the payee, The National Shawmut Bank, the sum of $1,000.00 plus 9 per cent annual interest on April 10, 1974.
A promissory note is negotiable, that is, it may be passed from one person or firm to another if signed by the payee, or by the person holding the note if payable to “bearer.” This signature the note is called the endorsement. If a note has been given by a buyer to a seller for merchandise, the seller, or payee, may discount the note at the bank by endorsing it in order to get his money before the due date. The buyer, or maker, then pays the bank for the note. If the buyer does not pay, the seller must repa the bank for the note and tries to collect from the buyer.
The term discount as used above means that the bank takes out the interest in advance. For instance, if a firm wishes to borrow $10,000 for 90 days (one-fourth of a year) at 8 per cent interest from a bank, the note may be made for $10,000 but the company gets only $9,800, which is $10,000 less the $200 interest. When a seller discounts a customer’s note to a bank, the computation is a little more complicated. First, the maturity value of the note must be computed, that is, the principal plus the interest to be paid at the due date. Second, the bank discount is computed on the maturity value, and the proceeds represent the maturity value less the discount.
A variation of the promissory note is often used for an installment purchase of equipment, machinery, and similar items. Commonly the buyer makes a down payment and agrees to pay the remainder plus agreed interest in periodic payments over a number of months or years. In effect, the buyer signs a series of promissory notes, each due at a specific time.
