What is Trade Credit?
Trade credit is a business-to-business (B2B) agreement in which a customer can purchase goods without paying upfront, settling the bill at a later approved date. Typically, businesses extend trade credits for 30, 60, or 90 days, logging the transaction through an invoice.
Think of trade credit as 0% financing, where companies acquire assets while deferring payments for a set value of the goods or services, sans any interest during this period.
Key Benefits and Takeaways
- Trade credit allows customers to procure goods and pay at a future scheduled date.
- It aids businesses in maintaining a positive cash flow and financing short-term growth initiatives.
- Handling trade credit can complicate financial accounting, depending on the accounting method.
- Typically, trade credit is widely supported globally, offering avenues for new financial technology solutions.
- Suppliers face a timing disadvantage, as they’ve dispatched goods but not received payment.
Delving into Trade Credit
Trade credit offers buyers substantial advantages. Some may even negotiate extended repayment terms, further enhancing financial flexibility. Sellers, on the other hand, generally set specific qualifications for granting trade credit.
For instance, a retail giant like Walmart leverages trade credit extensively to support its operations, paying retroactively for store inventory. In international trade, companies frequently utilize trade credit to facilitate transactions and manage cash flow more effectively.
The credit period duration is determined by the supplier and agreed upon by both parties, helping suppliers encourage early payments by offering discounts such as 2%/10 net 30.
Accounting for Trade Credit
Both buyers and sellers must account for trade credits meticulously, often influenced by whether the business employs cash accounting or accrual accounting. Public companies must use accrual accounting, recognizing revenues and expenses at the transaction time.
When offering trade credits, the revenues and related expenses must still be booked at sale, with unpaid receivables marked as accounts receivable. Defaults and offered discounts also invite potential financial adjustments like write-offs or write-downs.
Trade credit can resemble a 0% loan for buying businesses—it enhances the company’s assets without an immediate cash outflow, with no interest attached during the deferment period.
Evolving Trends in Trade Credit
For businesses lacking easy financing options, trade credit can be highly beneficial. Philanthropic financial technologies now propose alternatives to traditional trade credits, offering various point-of-sale financing solutions. These innovative tools mitigate trade credit risks for sellers while encouraging buyer growth.
Moreover, sellers can explore accounts receivable financing to procure capital upfront aligned with their trade credit receivables. Internationally, trade credit remains a crucial factor, with WTO stating that 80% to 90% of world trade hinges on trade finance.
Core Concepts and Associated Terms
Trade credit intricately links to broader financing themes such as credit ratings, trade lines, and buyer’s credit.
A credit rating evaluates a borrower’s creditworthiness, critical for trade credit approval. A poor rating may impede trade credit availability.
A trade line specifies a business credit account log, often tracked by agencies like Standard & Poor’s, Moody’s, or Fitch.
A buyer’s credit applies predominantly in international trade—a loan facilitating major purchases like capital goods, crossing financial borders.
Examining Pros and Cons of Trade Credit
For Buyers
Advantages: Eases financing access, cost-free. Enhances cash flows, fostering the sale of acquired goods sans upfront payment.
Disadvantages: Penalties for late payments, potential adverse credit impacts if settled late, straining supplier relationships.
For Sellers
Advantages: Cultivates customer loyalty, inspires more purchases due to risk-free credit facilities.
Disadvantages: Revenue delays, especially critical for tighter budgets. Risk of buyer defaults, potential bad debts impacting financial health.
Trade Credit FAQs
What are Common Terms for Trade Credit?
Typical terms are repayments within seven, 30, 60, 90, or 120 days, with early-payment discounts.
What Kind of Credit is Trade Credit?
Trade credit is a commercial financing extension permitting interval-based purchase payments at a 0% borrowing cost.
What Forms Can Trade Credit Take?
Forms include open accounts, promissory notes, or bills payable, all defining varied transaction and credit term specifics.
Is Trade Credit Expensive?
Traditionally, trade credit isn’t costly for buyers since it involves no interest. Failing to pay by due dates, however, can introduce late fees or interest.
The Bottom Line
Trade credit represents key commercial financing that aids businesses in optimizing operations without immediate financial burdens. Leveraging it judiciously can significantly smooth out cash flow while saving on traditional financing costs.
Related Terms: credit rating, trade line, buyer’s credit, financing, operating costs.
References
- Congressional Research Service. “Cash Versus Accrual Basis of Accounting: an Introduction”, Pages 3-4.
- World Trade Organization. “Trade Finance”.
- United States Federal Reserve System. “Small Business Credit Survey”, Page 19.
