What is Trade Credit: Types, Features, Benefits, Examples, Pros and Cons

Trade credit is a convenient way for businesses to manage short-term financing needs without relying on external loans or lines of credit. This mechanism is widely used across industries, particularly in retail, manufacturing, and wholesale sectors, where the timing of payments is crucial for maintaining a steady supply chain. In essence, trade credit helps businesses grow by providing them with the necessary goods to meet market demand while delaying payment, thereby optimising cash flow management.

What is trade credit?

Trade credit is a vital financial arrangement used in business transactions, allowing companies to purchase goods or services from suppliers without immediate payment. This arrangement offers buyers the flexibility to acquire necessary inventory or raw materials and pay for them at a later date, usually within 30 to 90 days. Trade credit effectively acts as an interest-free loan from the supplier to the buyer, enabling the buyer to maintain cash flow and operational liquidity. It also fosters strong relationships between buyers and suppliers, as it signals trust and reliability.

What is trade credit financing?

Trade credit financing is the practice of obtaining goods or services from suppliers with the agreement to pay for them at a later date. This form of financing is a short-term solution that allows businesses to purchase essential supplies without the immediate outflow of cash. By extending payment terms, suppliers provide buyers with the opportunity to generate revenue from the goods before payment is due.

Trade credit financing is particularly beneficial for small and medium-sized enterprises (SMEs) that may face cash flow constraints but need to maintain inventory levels to meet customer demand. It also enables businesses to invest in growth opportunities without the immediate burden of upfront costs.

Typically, suppliers offer trade credit on terms such as "Net 30" or "Net 60," indicating the number of days the buyer has to make payment. Trade credit financing is a widely accepted practice in various industries, and it plays a crucial role in maintaining the smooth operation of supply chains. It is a cost-effective financing option compared to traditional loans, as it often comes with minimal or no interest charges.

Types of trade credit

• Open account: This is the most common form of trade credit where goods are shipped, and the invoice is sent to the buyer with a specified payment due date. The buyer is expected to pay within the agreed timeframe, usually 30, 60, or 90 days.
• Promissory note: In this arrangement, the buyer issues a promissory note to the seller, agreeing to pay a specified amount at a future date. This type of credit may include interest, depending on the agreement between the parties.
• Bills of exchange: This is a written order by the seller directing the buyer to pay a specific amount at a future date. The buyer's acceptance of the bill formalises the agreement, making it a legally binding document.
• Instalment credit: In this type of trade credit, the buyer pays for the goods or services in agreed-upon instalments over time. This option is typically used for higher-value purchases and may involve interest charges.
• Consignment: Under consignment, the seller retains ownership of the goods until they are sold by the buyer. The buyer pays the seller after the goods are sold, which reduces the financial risk for the buyer.
• Revolving credit: This credit type allows the buyer to borrow up to a specified limit and repay it over time. Once repaid, the credit is available again for future use, similar to a line of credit.

Features of Trade Credit

The main features of trade credit are as follows:

• Treatment in the books of accounts:
  Trade credit given by a firm to another business is treated as an asset and appears in the accounts receivable. On the other hand, trade credit received by a firm from another company is treated as a liability and appears in the accounts payable section
• Short-term debt:
  Trade credit is usually considered a short-term debt with no interest charged in most cases
• Credit period:
  The credit period typically ranges from a week to a year, as trade credit is generally not a long-term arrangement. However, firms can adjust the credit period based on their convenience and repayment ability. The length of the credit period depends on various factors such as the perishability of goods, the size of the account, and the likelihood of the other party failing to pay

How does trade credit work?

Trade credit availability and terms differ widely between suppliers. Generally, the process involves these steps:

1. Approval process

Trade credit starts with an approval process. In the past, this was a manual task requiring employees' accounting knowledge, experience, and judgment. Nowadays, much of it is handled by advanced software that can make almost instant decisions. The software assesses credit history, projected turnover, and other factors.

2. Agreeing on credit value

After approval, the supplier decides how much credit to offer the borrower. This amount may depend on details found during the approval process or the relationship between the supplier and the borrower. For instance, the borrower might need to explain how they will use the credit to grow.

3. Setting payment terms

This includes more than just the repayment period. Trade credit works like an interest-free loan, with penalties and extra charges for late payments, such as fixed fees and interest on overdue amounts. Suppliers might also provide discounts for early payments.

How to record trade credit?

Recording trade credit in financial accounts is crucial for accurate bookkeeping and financial management. When a business receives goods or services on trade credit, it must record the transaction as both an asset and a liability. On the date of purchase, the value of the goods or services is entered as an inventory or expense on the debit side of the ledger, depending on the nature of the purchase. Simultaneously, the same amount is recorded as a trade payable on the credit side, reflecting the liability to the supplier.

As payment is made, the trade payable account is debited, reducing the liability, and the cash or bank account is credited, reflecting the outflow of funds. This process ensures that the financial statements accurately represent the company’s obligations and assets. Proper recording of trade credit is essential for maintaining financial transparency, complying with accounting standards, and ensuring that the business’s cash flow is effectively managed. It also allows businesses to track outstanding liabilities and manage payment schedules efficiently.

What is the cost of trade credit and how to calculate it?

• Understanding the cost: While trade credit often appears as an interest-free option, it may involve indirect costs, particularly when discounts for early payment are offered but not utilised.
• Calculation method: To calculate the cost of trade credit, use the formula: Cost of Trade Credit = (Discount % / (1 - Discount %)) * (360 / (Payment period - Discount period)).
• Example calculation: For a supplier offering terms of 2/10, Net 30, where a 2% discount is available if paid within 10 days, but the payment is made on the 30th day: Cost of Trade Credit = (2 / (100 - 2)) * (360 / (30 - 10)) = 37.24%.
• Interpretation: This calculation shows that the effective annual cost of forgoing the discount can be significantly higher than the interest on a short-term loan, making it crucial for businesses to consider the implications of their payment timing.

Advantages and disadvantages of trade credit

Examples of trade credit

What are the most common terms for using trade credit?

Trade credit terms define the payment conditions agreed upon between the buyer and the supplier. The most common terms include "Net 30," "Net 60," and "Net 90," which refer to the number of days the buyer has to make payment from the invoice date. Suppliers may also offer early payment discounts, such as "2/10, Net 30," where a 2% discount is provided if payment is made within 10 days, with the full amount due in 30 days if the discount is not taken. These terms are designed to encourage prompt payment while offering flexibility for the buyer. The specific terms offered can vary based on the industry, the relationship between the buyer and supplier, and the buyer’s creditworthiness. 

It's essential for businesses to understand and negotiate trade credit terms that align with their cash flow needs, ensuring that they can take advantage of discounts and avoid late payment penalties. Proper management of trade credit terms can lead to improved cash flow, reduced costs, and stronger supplier relationships.

Trade Credit Instruments

Most credit is given on an open account basis. This means the only formal document used is the invoice, sent with the goods, which the customer signs to confirm receipt. Both the company and the customer then record the transaction in their accounting books. Sometimes, for larger orders or if there might be payment issues, the company may ask the customer to sign a promissory note or IOU.

Promissory notes help clarify the credit agreement later. However, they are signed after goods are delivered. To ensure a credit commitment before delivery, a commercial draft can be used. The seller writes a draft requiring the customer to pay a specific amount by a certain date, sent to the customer’s bank with the shipping invoices.

The bank gets the customer to sign the draft before giving them the invoices. The goods are then shipped. If payment must be immediate, it is called a sight draft, and funds must be with the bank before shipping.

Even a signed draft is not always enough for the seller. In such cases, the seller might ask the bank to pay for the goods and collect money from the customer later. When the bank agrees in writing, it is called a banker’s acceptance. This document, backed by the bank’s reputation, becomes a liquid asset. The seller can then sell it (often at a discount) in the secondary market.

Alternatives to trade credit

Trade credit and its various forms can be useful to a company depending on their needs, future goals, and available resources. However, trade credit may not suit every business. The rise of B2B Buy Now Pay Later (BNPL) options has led many businesses to offer this alternative form of financing. Here are some alternatives to trade credit currently available to businesses:

• Bank loans:
  Businesses can approach banks and financial institutions for different types of loans, such as term loans, lines of credit, or asset-based loans. These loans provide upfront capital that can be used for purposes like purchasing inventory or funding business operations.
  The key difference between bank loans and trade credit is the barrier to entry. Bank loans typically require time-consuming paperwork, checks, and may involve high-interest rates or the need for collateral. Trade credit, however, is provided directly by suppliers without collateral or interest rates
• Accounts receivable financing:
  Also known as trade receivables financing or AR financing, this allows businesses to borrow money against the value of their accounts receivables. This method improves cash flow and helps businesses continue operations even when capital is tied up in receivables
• Debt factoring:
  In debt factoring, a third party, such as a bank or financial service provider, pays the business 80-90% of the invoice amount upfront and collects the payment from the buyer when the payment terms expire. This provides quick access to working capital while transferring the collection risk to the financing provider
• Supply chain financing:
  Supply chain financing works similarly to invoice factoring but in reverse. Instead of the seller seeking early payment for their invoice, the buyer receives financing to allow their supplier to be paid early. This helps maintain smooth cash flow within the supply chain and is also called "reverse factoring"
• B2B Buy Now Pay Later (BNPL):
  B2B BNPL is a form of short-term financing that allows business buyers to delay payment or split the cost of purchases over a set period. Similar to the B2C BNPL model, B2B BNPL provides interest-free trade credit to the buyer while ensuring the seller receives payment upfront, helping to reduce credit risk associated with net term payments

Conclusion

Trade credit is a vital financial tool that supports businesses in managing their cash flow and operational needs without immediate payment. Understanding the types of trade credit, how to record it, and the associated costs is crucial for businesses to make informed decisions. While trade credit offers significant advantages, such as improved cash flow and strengthened supplier relationships, it also carries potential disadvantages, including the risk of overextension and higher costs if not managed properly.

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