Credit TermsExplained & Defined

Written By:
Adiste Mae

What is a Credit Term? 

A Credit Term also called payment terms, is the term or terms stated in invoices stating the agreement of when a buyer must pay for the goods or services received.

It usually outlines the percentage of payment to be made at a particular date and other information as necessary. 

Types of Credit Terms

Several credit terms used when invoices are issued are the following:

Cash on Delivery (COD)

COD, also known as payable on receipt, means that when the item or service is delivered, the payment is also due to be collected. 

Advance Payment

Prior to the delivery of goods and services, the supplier demands that the invoice be paid first in part or in full. 

Prepayment

An invoice that needs to be prepaid means that the full amount is due before the delivery of the goods and service.

This is the complete opposite of Cash on Delivery (COD), wherein the buyer has to pay the full amount upon receipt of the item(s) ordered. 

Stage / Milestone Payment

This credit term is popular when it comes to projects where the product or the service can be completed in stages.

For example, the payment terms will be 50% advance payment, 25% on delivery of the goods and services, and 25% 30 days after the delivery. 

Bill of Exchange

In a bill of exchange, there is one important element present in the agreement: the presence of bank support for the payment of the invoice scheduled at a later date. 

N10, N30, etc. 

Credit sales are given these payment terms. N/10 or N/30 signifies the number of days that an invoice has to be paid.

For example, n/30 means that the invoice has a maximum credit period of 30 days. 

2/10, N/30

This credit term means that if an invoice is paid within 10 days, a 2% discount will be applied to the invoice.

The maximum credit period for the invoice to be paid is 30 days. 

2/10, N/30 EOM

EOM means End of Month so for invoices that have a term of 2/10, N/30 EOM means that an invoice paid within 10 days after the next month will get a 2% discount and it has to be paid no more than 30 days. 

2/10 ROM

With 2/10 ROM, ROM stands for Receipt of Goods Dating Method.

The invoice will have a discount of 2% if it is paid within 10 days from the date of the receipt of goods or services. 

Deciding the Credit Terms

A lot of what goes into deciding the credit terms to provide a company’s customer has to do with the risks that the company is willing to take.

For many businesses, selling on credit is another way to entice buyers to purchase, especially when the payment terms are favorable to the buyer.

This is called credit exposure. 

It is helpful for businesses to determine and implement a credit policy that serves as a guideline of how much credit the business can extend their customers including the credit limit to offer each client.

Also included in the policy is the process of approving credit for the customer, the necessary actions to take should the client violate the terms of credit and general exceptions to the policy. 

Factors Influencing Credit Terms

There are several factors that a company’s management considers before deciding on the credit terms to extend to their customers.

These factors have something to do with time, the credibility of the customer, and the interest rate to apply in case of non-payment within the agreed credit terms. 

Time Factor 

Prior to sending an invoice to a client, the time period for an invoice to be paid by the client is agreed upon.

The time period extended to the customer is giving them the benefit of settling the invoice well before it is due. 

Credibility Factor

When companies evaluate the credit terms to be extended to the customer, they first evaluate their creditworthiness or put simply, their ability to pay.

Other factors to be considered are the payment and transactions history of the client.  

Interest Rate Factor

Some companies include in their credit policy an interest rate to be applied on the full invoice amount or the unpaid part of the invoice.

This practice is to discourage customers, especially the habitual late payers, to delay payments on the invoices due. 

Tips to Manage Credit Terms

Extending credit terms to customers is not bad company practice.

On the contrary, it improves the relationship between suppliers and buyers.

However, credit terms can be better managed when there is an affecting Credit Policy in place.

This means that credit terms will not be the same for all the customers.

Essentially, the discretion is left with the management in deciding whatever works best for the interest of the company. 

To better manage the credit terms, here are a few of the tips that companies can consider:

Clearly State the Credit Terms on the Face of the Invoice

When customers receive invoices, they will immediately see the terms of payment on the face of the invoice.

When terms are clearly stipulated and are easily visible, it reduces the possibility of miscommunication and assumption on when they should pay the invoice. 

Evaluate Customers Individually

The creditworthiness of each customer will vary.

The company can then provide the credit terms depending on each of the customer’s evaluations. 

Set a Credit Limit for Each Customer

Each customer should have a credit limit – the total amount of purchases they can purchase on credit.

This helps companies limit the risk that some of the invoices will not get paid.

This can also help a company’s salespeople and collections officer understand the limits set for each of the customers and not oversell beyond the allowed limit. 

Automate Notifications

There are many accounting software that helps accountants be notified whenever the customers have already reached their credit limit, or if there are overdue invoices that need to be paid immediately.