What Is Trade Credit? Types, How To Record It, And Best Practices

Introduction

The B2B world runs on trade credit – it is an essential tool for financing growth. It is a financial agreement wherein sellers provide buyers with extended payment terms and let them buy now and pay later. 

However, it is not just a financial tool; trade credit helps create a mutually beneficial relationship between the supplier and buyer. But how does trade credit actually work? What is the cost of trade credit, its advantages, and disadvantages? Want answers to all these questions? 

In this blog we’ll be covering all this – so let’s get to it.

What Is Trade Credit?

Trade credit is a form of commercial financing extended by suppliers to their customers for the purchase of goods or services. It allows businesses to obtain the necessary resources to operate and grow without the need for immediate cash payments. 

For example, if Company A orders 1 million chocolate bars from Company B, then the payment terms could be such that Company A has to pay within 30 days of receiving the order. This arrangement between the two companies is generally known as trade credit. 

The credit limits offered to the buyers generally vary depending on their credit history and relationship with the seller or the service provider.

In short, trade credit ensures smoother interactions between businesses, optimizing financial arrangements for successful transactions.

What is Trade Credit Financing?

Trade credit is a business arrangement where the supplier allows the customer to purchase goods or services on credit and pay for them at a later date. It allows businesses to obtain the necessary resources to operate and grow without the need for immediate cash payments.

For example, if Company A orders 1 million chocolate bars from Company B, then the payment terms could be such that Company A has to pay within 30 days of receiving the order. This arrangement between the two companies is generally known as trade credit. 

The credit limits offered to the buyers generally vary depending on their credit history and relationship with the seller or the service provider.

In short, trade credit financing ensures smoother interactions between businesses, optimizing financial arrangements for successful transactions.

Types Of Trade Credit

Trade acceptance, promissory notes, and open accounts are the three primary categories of trade credit. Trade credit is a common tool used by businesses to boost sales volume, cultivate lasting relationships with clients, and foster client loyalty. 

It is essential to understand the many kinds of trade credit that are available in order to maximize this financial arrangement and ensure smooth business dealings. 

• Open account

  Smaller businesses often don’t sign a formal agreement with their customers while extending trade credit. Such a system is called an open account.

• Trade acceptance

  When the seller and buyer have a formal agreement for extending and receiving trade credit before the sale, it is called a trade acceptance. Before the seller ships the goods or provides their services, the buyer must sign the agreement.

• Promissory note

  It is a debt instrument where the buyer promises to pay a particular amount to the seller before the due date. It is also a formal agreement between the two parties before the sale goes through.

How Do You Record Trade Credit?

The way you record trade credit depends on your company’s accounting method – cash accounting or accrual accounting. In the cash accounting method, transactions are recorded when the money is credited. Trade credits are recorded when payments are made or received, and they directly impact cash flow.

On the other hand, in the accrual accounting method, trade credits are recorded at the time of the transaction, whether or not money has been credited. Sellers list trade credits under accounts receivable, while buyers maintain them under accounts payable. 

For example:

When a buyer pays a vendor, the amount is deducted from the buyer’s accounts payable and recorded as an expense.

On the seller’s side, the payment received reduces their accounts receivable and is recognized as income.

In cases where customers fail to make payments, businesses may adjust their accounts receivable and write off bad debts as expenses.

For publicly traded corporations, accrual accounting is mandatory. This accounting method ensures that companies maintain precise records and adhere to proper financial reporting practices.

What is the Cost of Trade Credit and How to Calculate It?

The cost of trade credit refers to the discrepancy between the cash and credit prices for a product or supply. Suppliers charge client companies with credit purchase contracts a higher price for the convenience of buying on credit. 

Additionally, a supplier’s credit policy and trade terms influence the overall cost of trade credit for a business. Understanding these terms and conditions is crucial for making informed financial decisions.

1) Early payment discount

Every supplier or service provider wants to receive their payments as early as possible, but they cannot enforce strict credit terms because that would reduce their sales. So, most companies employ the early payment discount method.

In this method, a business offers its customers a flat discount for paying within a particular time frame. Let’s say a business generally offers a credit period of 30 days. To entice customers to pay earlier than the allowed 30 days, the business would offer a 2.5% discount (an early payment discount) to customers who pay within 10 days.

An important point to note here is that most of the time, the discounted amount is the product’s real value. So, customers availing the whole credit period often pay a small premium for the goods or services.

2) Late payment penalties

It is no secret that most service providers often charge late payment fees to improve their cash flow. However, during the pandemic, late payments have increased significantly. A report from Brodmin suggests that more than 50% of businesses are expecting delayed payments.

To avoid such penalties, customers should be cautious by having an emergency cash reserve or ordering conservatively to ensure timely payments. In some cases, late fees can be as high as 10-15% annually.

Businesses should prioritize paying their suppliers on time to maintain a clean credit record and strong relationships with sellers. However, if unforeseen circumstances cause a delay, contacting the seller and explaining the situation may lead to the waiver of late penalties if the reason is genuine.

Advantages and Disadvantages of Trade Credit

Now that you understand that taking or giving trade credit involves a cost, you must be wondering why to do it. Well, there are several reasons why a company might consider giving or accessing trade credit and paying for the cost of trade. If you are considering offering or taking trade credit, here are some important pros and cons to consider.

Buyers (receiving trade credit)

Sellers (offering trade credit)

Best Practices for Extending and Utilizing Trade Credit

Offering or receiving credit is an inevitable aspect of B2B transactions, as in many industries, vendor trade credit is the norm. For buyers, it is often a necessary part of doing business. The key lies in controlling your credit and payment terms. 

To maximize the benefits, both sellers and buyers should adhere to best practices. Let’s explore some guidelines to make the most out of trade credit arrangements.

1. Order cautiously: Many businesses tend to place large orders to secure lower prices, and it’s understandable, especially when you have the luxury of deferred payment. However, this approach can backfire if your inventory remains unsold. To mitigate risks, opt for conservative ordering and place the next order only when you are nearly out of inventory.
2. Maintain a cash reserve: The pandemic has highlighted the importance of being prepared for market uncertainties. Building a cash reserve allows you to make timely payments, even if you don’t meet your sales goals.
3. Look for smaller businesses: Working with smaller vendors often provides advantages in negotiating favorable payment terms. Smaller businesses are more likely to offer higher credit limits and longer payment periods compared to larger enterprises.

1. Check your customer’s credit history: One of the biggest mistakes most businesses make when giving credit is not effectively analyzing their customer’s credit history.
   Making this mistake can lead to your receivables turning into bad debt. Therefore, having a process of checking credit history is critical. However, it should not be a one-time check. Automating credit checks helps conduct periodic reviews and is the key to reducing risk and bad debt.
   HighRadius’s RadiusOne Credit Risk Application can assist your business in customer credit checks and faster customer onboarding. It utilizes industry-based best practices to provide you with a customer risk score and credit limit. However, the most useful feature is the real-time credit risk alert and periodic credit reviews that help your business mitigate any potential risk.
2. Insure your trade credit: Depending on a business’s industry, the risk score of their customers, their geographical locations, and past records, a trade credit insurance could make sense. It’s all about whether the insurance cost is lower than the potential loss of money in case receivables can’t be collected. It can be beneficial for those dealing with high-risk customers from different countries.
3. Finance trade receivables: If your business needs cash for operations, then financing your receivables is a good idea. There are two primary ways to do it: invoice discounting and factoring. In both cases, a third party is involved, and the invoice sells for a 10%-30% discount. As a business, you get the cash, and when the customer pays for it, the third party receives it.

Examples of Trade Credit

Let’s understand how trade credit works across different industries, using a few examples below.

How HighRadius’ Credit Management Software Can Streamline Your Business 

Trade credit plays a vital role in B2B transactions. It empowers companies to navigate uncertainties, seize growth opportunities, and maintain a competitive edge. 

At HighRadius, we offer comprehensive solutions designed to streamline and automate your credit and collection operations, empowering you to make informed credit decisions while mitigating risk.

Our AI-based credit cloud facilitates automated credit reviews and proactive credit risk management, featuring a prioritized credit worklist and AI-driven blocked order management. With our solution, organizations can automatically calculate credit scores, determine risk classes, and establish credit limits using pre-configured credit scoring models.

By leveraging advanced analytics and real-time data provided by our credit and collection solutions, organizations can make data-driven credit decisions, resulting in reduced bad debt and improved cash flow.

FAQs

1) What does trade credit include? 

Trade credit is a short-term finance option for businesses that allows them to purchase goods and services on credit, avoiding the need for immediate cash or check payments. It makes the exchange of goods and services easier for buyers while improving the cash flow for sellers. 

2) Is trade credit a debt?

Trade credit appears on a buyer’s balance sheet as accounts payable (AP) and a supplier’s balance sheet as accounts receivable (AR). For example, a small business buys $1,000 worth of goods from a supplier with 30 days to pay. Until they settle the bill, they have trade credit with the supplier. It’s a debt because they owe the supplier money, but it’s more like a short-term loan without interest.

3) Who uses trade credit?

Trade credit is a financial tool that is used by businesses of all sizes and across various industries to manage cash flow and procure goods or services from suppliers without the need for immediate payment. It provides businesses the flexibility to manage their purchase and payments process. 

4) Is trade credit long or short-term?

Trade credit is provided for a short-term period which ranges between 30-120 days.

5) What are the benefits of trade credit?

Trade credit is beneficial for both suppliers and buyers. For buyers, it allows them to purchase goods and services without immediate payment. Moreover, they get to pay the amount at a later date with no interest. For sellers, it allows them to attract more customers and close bigger deals. 

6) What is trade credit insurance?

Trade Credit Insurance is a protection against bad debts that occur when the customer is either unable to pay or pays after the due date. It’s kind of a support that’s provided to the suppliers in case there’s a delay in payment or no payment is made.