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Trade Credit and Promissory Notes

Trade Credit and Promissory Notes

Author: James Howard

This lesson discusses some unsecured short term financing options for organizations.

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Hello, and welcome to this tutorial on Trade Credit and Promissory Notes. Now as always with these tutorials, please feel free to fast forward, pause, or rewind, as many times as you need, in order to get the most out of the time that you'll spend here.

So let me ask you a question, what is it that short term financing looks like? How do we recognize it? What are the different ways that we can have a short term financing? Well, during this tutorial, what we're going to be looking at is short term financing. We're also going to be looking at types of short term loans. The key terms for this lesson are going to be unsecured financing, prime interest rate, trade credit, and promissory note.

So let's go ahead and start talking about short term financing. Now short term financing is a normal aspect of business, and it doesn't necessarily mean that a business is in distress. It could just be something we have to do to get over a particular moment or problem that we're dealing within the business. So just because somebody has a short term financing plan, it doesn't necessarily mean that they're in trouble. It's a normal thing to have a type of short term financing available.

Now short term financing is typically paid within a year of the time that the loan is made. It's also a lot easier to get than long term financing, and so it makes it really attractive for smaller businesses, also. Now short term financing doesn't necessarily require collateral, and therefore it's referred to as unsecured financing. Now unsecured financing is a loan of funds based solely on an agreement between two parties that one will pay the other. No physical items are offered as collateral on the loan.

So an unsecured short term loan is simply my promises-- it's backed only by my promise that I will pay the money back. Now short term financing is typically easier for businesses to get because the short repayment period has been shown to be less risky to the lender-- there's more of a guarantee they'll get the money back that they loan. Also, the amount borrowed is typically smaller then with long term loans. So we don't have to worry about a big, big payback along the way. And typically, there's a working relationship between the lender and the lendee. With unsecured short term bank loans for instance, the bank will usually charge something called a prime interest rate. Now the prime interest rate is the interest rate banks charge to their best commercial customers. And these folks are very credit worthy businesses. They receive the best rate possible.

Now less credit worthy businesses may have a prime interest rate plus a percentage. And it's important to note here that annual percentage rate, or APR, is similar, but it's going to affect consumers and is generally higher than that given to businesses. In fact, if you look at the back of your credit card statement, you'll notice sometimes that you'll see prime, or prime interest rate plus a certain percentage. That refers to your particular annual percentage rate, and how they set that rate for your credit card.

Now there are certain types of short term loans we want to look at. The first one is called a trade credit. This is credit which suppliers extend it to their customers for a specific period of time usually 30, 60, or 90 days. And this is just one optional short term loan. Now here, retailers will use these delayed payments to deal with merchandise issues, or to buy inventory. Also, for start ups, will use this also to buy inventory, as well. If they need to get through a specific short period of time-- stock my shelves-- I don't necessarily have the cash on hand to make the purchase. Like we said, these are usually between 30 and 90 days, but sometimes they can be longer.

Now the seller, or the loan-- the person who's giving the trade credit here, is typically going to offer a discount to the buyer if they pay at the time of delivery, or they can pay up to the full amount with no discount at a later date. So I pay a certain amount of the entire amount at the time the purchase is made, I get a discount off the price that I paid for it, but I don't get a discount if I take that later date-- that 30, 60, or 90 day amount of time, in order to pay that bill. Now considering accounts payable, for instance, it is expected that any credit worthy business would take advantage of trade discounts when they can, so if no trade discount is offered, being able to withhold that payment for 30 to 120 days without paying interest will improve the purchaser's cost of funds and provide a greater control over that business's cash flow.

So again, if I buy a purchase, or buy something from a supplier-- say, a whole bunch of shirts, he may offer me a discount for buying that thing right now. So if I get that discount, man, I really want to use it, so I'll go ahead and pay that money up front to get the discount. But if they don't offer it, then there's really no benefit for me trying to pay that bill early. So then I'll hold that bill for 30, 60, 90, 120 days-- how ever long the trade credit lasts-- so I can control and hold my money within my bank account a little bit longer. So it will really help the lendee, in this case.

Now the next little look at are promissory notes. Now promissory notes is an agreement to pay a specific amount of money at a certain time under certain conditions, and this is simply another short term financing option for businesses. Here, the borrower is going to sign a legal instrument promising to pay the lender by a specific amount of time, a specific amount of money. Now interest here is normally charged. And a typical promissory note will be the somewhere between 60 to 180 days. It's a legal document and it can be used in court.

Now it can also be sold and negotiated. For example, a company can sell the note to a bank it does business with. Now if the note is discounted, the value of amount that the supplier would receive is a little bit less than the value they would receive if it was at maturity. If they sold this particular item. And this is because the bank is going to be taking a small cut along the way.

Now the benefit here for the supplier, though, is the supplier gets the money a lot quicker, and the bank makes money when the borrower pays on that maturity date. So here it really is a win for everybody involved. Supplier gets their money faster, they can put that money to use in things that they need to use that money for. The bank holds the promissory note. It pays a little bit less for it, so when they get that promissory note paid back fully by you, they make a little bit of money at the end and you get to take advantage of the cash that you got from the promissory note to do the things that you want to do.

So what did we talk about today? Well, we looked at short term financing, and we also looked at types of short term loans-- both promissory notes and trade credits. Now as always, I want to thank you for spending some time with me today, and you folks have a great day.

Terms to Know
Prime Interest Rate

The interest rate banks charge to their best commercial customers.

Promissory Note

An agreement to pay a specific amount of money at a certain time or under certain circumstances.

Trade Credit

Credit which suppliers extend to their customers for a specific period of time, usually 30, 60 or 90 days.

Unsecured financing

A loan of funds based solely on an agreement between two parties that one will pay the other; no physical items are offered as collateral on the loan.