- Trade credit serves as a financial arrangement where suppliers extend the flexibility of obtaining goods or services on credit to customers.
- The recording method for trade credit varies based on your company’s chosen accounting approach—cash accounting or accrual accounting.
- Extending trade credit is crucial for businesses to win new contracts and increase sales volume, but to maximize the benefits, adhering to best practices is crucial.
Trade credit is a crucial aspect of B2B transactions, wherein sellers extend payment terms to buyers, allowing them a specified time to settle the amount owed. This practice nurtures robust business relationships between sellers and buyers and fosters trust in the commercial landscape.
Moreover, the flexibility in payment terms facilitates smoother transactions between companies, creating an environment conducive to seamless business interactions.
In this article, we will cover:
- What is trade credit
- Types of trade credit
- How to record & manage it
- Its pros and cons
- Best practices for trade credit management
Whether you are an established enterprise or a growing business, understanding trade credit can empower you to optimize your financial operations and strengthen your partnerships.
Without wasting time, let’s get started:
What Is Trade Credit?
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 ensures smoother interactions between businesses, optimizing financial arrangements for successful transactions.
Types Of Trade Credit
There are mainly three types of trade credit: open account, trade acceptance, and promissory note. Businesses typically offer trade credit to increase their sales volume and build strong customer relationships over time, encouraging customer loyalty.
Understanding the different types of trade credit available is essential for optimizing this financial arrangement and ensuring seamless business interactions.
Smaller businesses often don’t sign a formal agreement with their customers while extending trade credit. Such a system is called an open account.
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.
It is a debt instrument where the buyer promises to pay a particular amount before the due date to the seller. It is also a formal agreement between the two parties before the sale goes through.
How Do You Record Trade Credit?
How 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 money changes hands. 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 exchanged hands. Sellers list trade credits under accounts receivable, while buyers maintain them under accounts payable. For example:
- When the buyer pays the seller, it’s recorded as an expense and reduces their accounts payable.
- The seller records it as income and decreases their accounts receivable.
- If customers fail to pay, businesses may write off the bad debt as an expense and adjust their accounts receivable.
Public companies are required to use the accrual accounting method.
These accounting practices ensure businesses accurately track their financial transactions and maintain proper records.
What Is the Cost of Trade Credit and How to Calculate It?
The cost of trade credit refers to the discrepancy between the cash price and the credit price 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.
To calculate the early payment discount, use the following formula:
Early Payment Discount = Invoice Amount x (Discount %)
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.
To calculate late payment penalties, use the following formula:
Late Payment Penalty = Invoice Amount x (Penalty %)
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.
The Pros and Cons Of Extending Or Receiving 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 taking on the related 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)
Trade credit is very affordable for buyers and practically free if paid on time. There is also a discount associated in most cases if you pay early.
The average late fee charged for delayed payments is 1.5% per month. So, if a customer is unable to pay on time, the credit gets very expensive.
Businesses that struggle to maintain a healthy cash flow find trade credits useful. It helps allocate funds to expand business operations rather than paying for goods or services in advance.
Sometimes a business might find it challenging to pay back on time because of the short-term nature of trade credit. In such cases, it’s better to look for long-term financing options.
Using trade credit options offered by businesses and always paying on time is a great way to improve your business credit score.
If a customer is unable to pay back on time, it could even hurt their credit score or rating.
Sellers (offering trade credit)
By offering trade credit and payment flexibility, B2B businesses are often able to see an increase in their sales volume. It also makes it easier to bag larger orders.
If a business operates on low profits and is not cash-rich, then offering trade credits to customers could be a problem. It will lead to delayed revenue and may impact business operations.
By extending trade credit, it becomes easier to attract smaller businesses and have an advantage over the competition. It’s because these businesses often have cash problems and find it easier to pay their suppliers once they receive the payment from their customers.
Businesses need to be proactive and have an effective collections team to collect credit dues on time. This creates an extra cost for the company and puts more pressure on the AR team. The DSO or the average collection period of businesses might rise significantly if their collection process isn’t efficient.
Businesses offering trade credit to customers are seen as more financially secure. It also gives them an advantage over the competition.
Undue trade credits are often the cause of bad debt. Many companies that offer trade credit indiscriminately face cash flow challenges.
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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
In conclusion, trade credit plays a pivotal role in B2B transactions. It empowers companies to navigate uncertainties, seize growth opportunities, and maintain a competitive edge.
However, it also presents challenges for businesses. By controlling their credit and payment terms, businesses can make the most of trade credit, driving growth and success in the ever-evolving commercial landscape.
Whether you are a seller or buyer, following the best practices given above is essential to navigate the world of trade credit successfully.
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.
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). However, it can also be thought of as debt without any interest.
3) Who uses trade credit?
Trade credit is predominantly used by small businesses to finance their operational costs.
4) Is trade credit long or short-term?
Trade credit is provided for a short-term time period which ranges between 30-120 days.
5) What are the benefits of granting trade credit?
Extending trade credit can prevent buyers from looking elsewhere. Additionally, it acts as an effective way for businesses to win new contracts and increase sales volume.
6) What is trade insurance?
Trade Insurance is a protection against bad debts which occur when the customer is either unable to pay or pays after the due date.