What is Trade Credit

What is Trade Credit

What is Trade Credit

Trade credit is a business-to-business (B2B) agreement where a customer can purchase goods or services without paying cash upfront. It is agreed that instead of paying now it will be paid at a later scheduled date. Businesses that operate with trade credits usually give buyers 30, 60, or 90 days to pay for the transaction.

It can be thought of as a kind of 0% financing, this is always a good thing. Being able to use someone elses money for a certain period of time with no interest. This helps increase a company’s assets while deferring payment for goods or services to some time in the future.
Trade credit is a vital component of business transactions, acting as a flexible tool for financing short-term growth. This article will delve into the concept of trade credit, its advantages, disadvantages, and some practical examples.

Types of Trade Credit

There are mainly three types of trade credit: trade acceptance, open account, and promissory note.

  1. Open Account: This is the most common type of trade credit. It’s where the seller gives the products along with the invoice to the buyer. The seller then trusts that the buyer will pay for these products or services in the given period of time. Smaller businesses usually don’t have formal agreements with their customers while extending trade credit.
  2. Trade Acceptance: This is a formal document where the buyer signs an agreement, agreeing to a certain payment date for products or services. It’s a contractual obligation laying out the agreed terms providing the existence of a debt and it is widely used in international trading. Unlike a common bill of exchange, a trade acceptance becomes a legal obligation. A trade acceptance is drawn up and accepted by a buyer, not a bank. But a trade acceptance document can be sold to a bank or investor at a discount.
  3. Promissory Note: This is a signed document with a written promise to pay an agreed upon amount to a specific person, or the bearer, on a certain date or on demand. A promissory note typically contains all the terms pertaining to a debt, like the principal amount, interest rate, date of maturity, date and place of issuance, and issuer’s signature. Although financial institutions, such as banks may issue them, promissory notes also allow companies and individuals to get financing from a non-bank source. This source can be an individual or a company willing to carry the note (while providing the financing) under the agreed-upon terms. In effect, promissory notes can enable anyone to be a lender.

Advantages of Trade Credit

Trade credit can offer several benefits to both the buyer and the seller:

  1. Enhancement of Cash Flow: Trade credit can significantly boost a business’s cash flow. By delaying payments of cash, businesses can use their available money for investments or other immediate needs. This delay in payment allows businesses to better manage their cash resources.
  2. Building and Strengthening Business Relationships: Trade credit can serve as a tool for building and strengthening relationships between businesses and their suppliers. By extending credit, suppliers show trust in their customers, which can bring about loyalty in the business and lead to long-term relationship.
  3. Promoting Business Growth and Increasing Turnover: Trade credit can be a great stepping stone for business growth. By providing goods or services on credit, businesses can increase their sales volume, which in turn increases turnover. This can give businesses that are able to reach these kinds a trade agreements a competitive edge in the market.
  4. Support for New Businesses: Trade credit can be a lifeline for new businesses that may struggle to secure traditional funding or business loans. It allows these businesses to receive the necessary stock and materials for their operations without having to pay for them immediately. This can be particularly beneficial for businesses without an established trading history.
  5. Winning New Contracts for Suppliers: For suppliers, offering trade credit can be an effective strategy to get new contracts with businesses. By extending credit terms to their customers, suppliers can attract more business and increase their sales numbers.
  6. Encouraging Early Payments: Suppliers usually offer discounts to customers who pay their invoices before they are due. This is a common practice with trade credit, as it encourages customers to make early payments. This in turn gives the suppliers more money to get more inventory and be able to make more money with other businesses.
  7. Ease of Arrangement and Maintenance: If a business has shown they can make payments on time or even early, basically having a good credit history with the supplier and meets any other agreed requirements then arranging and maintaining a trade credit agreement is generally straightforward and hassle-free.

While trade credit offers numerous advantages, it’s important to remember that it also carries some disadvantages.

Disadvantages of Trade Credit

Despite its advantages, trade credit also has its downsides:

  1. Missed Discount Opportunities: When suppliers offer a discount for early payment, businesses that decide not to take advantages misses out on these savings. Also when a supplier offers discounts for a cash payment and the business opts for a trade credit they miss out. This essentially increases the cost of the goods or services purchased.
  2. Increased Input Costs: Businesses that are granted extensions or have longer credit terms often face higher prices from their suppliers. This can lead to an increase in the cost of these products or services, which in turn raises the cost of the finished goods.
  3. Potential Damage to Business Reputation: Businesses that consistently miss payments can harm their reputation with their current supplier and possible future ones.
  4. Risk of Losing Suppliers: Not being able to comply with the agreed credit terms can lead to strained relationships with suppliers, and in some cases, the loss of the supplier altogether.
  5. Additional Financial Costs: If a business does not adhere to the agreed credit terms, it may be subject to interest charges. These additional costs increase the overall cost of the goods or services.
  6. Dependence on Suppliers: Heavy reliance on a supplier for trade credit can lead to a dependency on that supplier. This could become a real problem for the business if the supplier faces limited supply, financial difficulties or other problems.
  7. Administrative Burden and Financial Risks for Suppliers: For suppliers, offering trade credit can increase the positions needed at the administrative level. This would be due to the need for careful management of customer accounts. Additionally, there’s the risk of businesses not paying their debts and cash flow mismatches, as there’s no guarantee of timely payment from buyers.

An Example of Trade Credit

Trade credit is usually offered for 7, 30, 60, 90, or 120 days, but a few businesses, such as goldsmiths and jewelers, may have longer periods of time to pay.
For example, a customer is granted credit with terms of 5/12, net 60. This means that the customer has 60 days from the invoice date to pay the seller. In addition, a cash discount of 5% from the agreed sales price will be given back to the customer if payment is made within 12 days of invoicing.

Trade credit is a powerful tool that can help businesses manage their cash flow and foster growth. However, like any financial instrument, it comes with its own set of risks and rewards. Understanding these can help businesses make the most of trade credit and use it effectively to drive their success.