What Is Trade Credit And How Does Trade Credit Work?

Many businesses struggle to stay on top of their cash flow while purchasing raw materials, managing inventory and supplies from vendors, and settling their accounts immediately. This is where trade credit can benefit both the supplier and the customer. Trade credit involves purchasing goods and services from vendors for business without making an immediate payment.

Essentially, the goods/services are ordered from a vendor on credit, with a promise of repaying them later. The credit management team employs various methods of analysis, credit reports, and predictive analytical tools to determine whether to offer trade credit to customers. This article takes you through all the details about trade credit. Keep reading!

What is Trade Credit? 

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. 

Understanding Trade Credit 

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. 

Features of Trade Credit 

Some of the features of trade credit that makes it an attractive option for business and buyers include:

• Trade credit is an internal agreement between buyer and seller.
• The credit period is usually for a specific number of days, as decided by both parties. The credit period is determined by several factors, including the size of the account, and the likelihood of the other party breaching their commitment.  
• It helps improve a business’ cash flow while decreasing working capital requirements.
• No interest or late fee is charged if payment is made within the prescribed period. 
• Trade Credit is typically treated as a short-term debt with no interest.
• Funding is contingent on the company’s establishment, financial history, repayment history, and the enterprise’s terms with the supplier. 

Trade Credit Accounting 

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.

Trade Credit Trends 

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. 

Also Read: Line Of Credit: Definition, How It Works, Types, Benefits And How To Apply

Benefits of Trade Credit 

For buyers 

• Trade credit can help businesses manage their short-term cash flow issues. 
• There is no interest for payments made on time.
• Helps maintain long-term relationships with suppliers.

For sellers 

• Offering trade credit is an excellent way for suppliers to build trust with new customers. 
• When distributors allow customers to purchase supplies and materials on trade credit, they generate more revenue. 
• Trade credit can assist in increasing sales. It can help in increasing revenue by expanding the business network. 

Disadvantages of Trade Credit 

For buyers  

• Trade credit can be costly if enterprises do not settle your account on time, there may be significant penalties on late payments. 
• Defaulting payments could jeopardize the relationship with the supplier.

For sellers

• There is always the possibility that some customers will not pay back what they owe. 
• The supplier may face cash flow issues if several customers are late with their payments.
• The early payment discount results in a lower profit margin if the customer fails to pay on time. 

Also Read: A Detailed Guide on Unsecured Business Loan: How To Apply, Benefits And Eligibility Criteria

Final Word 

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.

FAQs on Trade Credit

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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.