Trade credit is a business agreement between a buyer (borrower) and the supplier. It facilitates the exchange of goods and services between two parties without immediate exchange of money, and the supplier accepts a deferred payment for goods and services delivered to the buyer. When a commodity or service seller allows the buyer to pay later, the seller has granted the buyer trade credit.
Trade credit allows the buyer to make payments after the transfer of goods and services, which helps businesses better manage their short-term cash flows.
Trade credit’s popularity has skyrocketed in recent years. Businesses rely on the trade credit system because funding from other sources, such as banks and financial institutions, is costly and a hassle with unending paperwork and compliances. Even healthy businesses sometimes cannot qualify the stringent eligibility criteria to obtain business credit from banks and financial institutions.
Vendors or suppliers credit the product or service rendered to the buyer. The buyer is given a specific period before which they must pay the supplier the dues.
Suppliers typically offer the credit for a set number of days and can extend it for a longer period if both parties agree. When trade credits are involved, many suppliers use early payment discounts to encourage early payments.
Some of the features of trade credit that makes it an attractive option for business and buyers include:
For accounting purposes, trade credit extended by one company to another is treated as an asset and appears in the Accounts Receivable section. Similarly, trade credit received by a company is treated as a liability and falls under the Accounts Payable section on the balance sheet.
On the balance sheet, trade credit can function similarly to a loan with 0% interest. When a supplier delivers goods to a buyer and accepts payment later, the supplier effectively finances the buyer’s purchase.
The terms and conditions under which trade credit is extended are critical in understanding its importance compared to bank credit and thus the extent to which it is used and supplied. With the emergence of small businesses and limited financial assistance, many fintech companies collaborate with sellers at the point of sale to offer 0% or low-interest financing on purchases.
Trade credit has also given sellers new financing options for accounts receivable financing, which provides businesses with capital based on their trade credit and accounts receivable balances. These collaborations help reduce trade credit risks for sellers while supporting buyer growth.
Trade credit is critical for businesses that have running purchases from their suppliers. Since a buyer has more time to complete their purchase by paying the vendor, trade credit improves their cash flow and working capital requirement. However, effective use of trade credit demands careful planning to avoid unnecessary costs such as the loss of cash discounts or the imposition of default penalties.
Ans: The factors that influence the trade credit period are:
– The relationship between the buyer and seller
– The buyer’s creditworthiness
– The quantum of credit
Ans: Trade credit is a type of commercial financing that allows a company to purchase goods without having to pay for them immediately.
Ans: It is like an interest-free loan that allows a buyer to obtain goods with pay later option at no additional cost.
Ans: If you use trade credit to finance an order, it is best to have enough cash on hand. If your business slows down due to unforeseeable circumstances, you will still be able to settle your debts.
Ans: Trade credit allows cash-strapped small businesses to obtain the goods they require without collateral or taking loans at exorbitant interest rates.
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