What is credit in accounting?

What is the meaning of credit in accounting

In accounting, credit has a specific meaning that’s different from its everyday definition. In everyday finances, credit refers to the ability to borrow money or purchase goods/services with the arrangement to pay later. In accounting, credit refers to a bookkeeping entry that typically increases a liability or equity account and decreases an asset account.

Imagine accounting as a giant balancing scale. Debits and credits represent the two sides of the scale. For every transaction, the total debits must always equal the total credits to maintain balance.

Types of credit

Understand the different types of credit and their sources to evaluate your options for funding.

Bank credit

Traditional banks and financial institutions are the most common source of credit. They offer a variety of loan products like mortgages, auto loans, personal loans, and business loans. These are often categorised under revolving credit and instalment credit.

Generally, banks have stricter creditworthiness requirements (minimum credit score and income level) but may offer lower interest rates due to the perceived lower risk.

Non-bank credit

Some examples of non-bank credit include loans from credit unions, peer-to-peer lending platforms, and online lenders. These institutions may have more flexible creditworthiness than traditional banks. However, non-bank lenders often charge higher interest rates to compensate for the increased risk.

Trade credit

Trade credit is extended by suppliers to businesses. When a business purchases goods or services from a supplier, they may be offered the option to pay for them at a later date, typically within a set timeframe (e.g., net 30 days – meaning payment is due within 30 days of the invoice date).

Trade credit essentially allows businesses to finance their inventory purchases without borrowing money from a bank. It’s important to manage trade credit effectively to avoid late payment penalties and maintain good relationships with suppliers.

Examples of business credit transactions

Line of credit

Businesses can access a line of credit, similar to a credit card, but specifically for business needs. They can withdraw funds up to a certain limit and repay them with interest over time, with the available credit being replenished as repayments are made. Useful for managing working capital or covering operational expenses.

Term loan

Businesses can borrow a fixed amount of money for a specific purpose, such as equipment purchase or expansion, with a set repayment schedule and interest rate.

Equipment loan

Financing the acquisition of specific equipment is often done through equipment loans. The borrowed amount typically matches the equipment’s cost, with repayment occurring over the equipment’s useful life.

Accounts payable

When a business purchases goods or services from a supplier on credit, it creates an accounts payable. This represents the amount owed to the supplier, typically with a set timeframe for payment (e.g., net 30 days).

Merchant cash advance

This financing option provides businesses with an upfront sum of cash in exchange for a percentage of their future sales.

Credit works by allowing individuals and businesses to borrow money from lenders, which is then repaid over time with interest. Lenders assess the borrower’s creditworthiness, or ability to repay the loan, based on factors such as credit history, income, and existing debt. The terms of the credit agreement, including the interest rate and repayment schedule, are outlined in a contract that both parties must agree to before the loan is disbursed.

By responsibly managing credit and making timely payments, borrowers can build their credit score and increase their access to credit in the future.