What is Trade Credit? – Example, Types, Cost, Pros, and Cons

What is trade credit?

Trade credit is a financing arrangement in which a supplier allows a customer to purchase goods or services on credit, with the payment due at a later date. It is a common form of short-term financing used by businesses to manage their cash flow and working capital.

The credit limits offered to the buyers generally vary depending on their credit history and relationship with the seller or the service provider. Mid-sized businesses often have a more informal trade relationship, while enterprises take a more calculated and formal approach.

Types of Trade Credit

There are three main types of trade credit. They are:

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 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?

The direct costs of trade credit

Although the concept of trade credit is simple, it often comes with some additional terms and conditions. These details affect the business and the customer to a considerable degree. Therefore, it’s essential to know what they are.

1) Early payment discount

Suppliers or service providers would naturally want to receive their payments as early as possible. However, 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

A report from Brodmin suggests that more than 50% of businesses are expecting late payments due to the pandemic. Therefore, service providers are inclined to charge late payment fees to improve their cash flow. 

Customers should take extra precautions like having an emergency cash reserve or ordering conservatively to ensure that they are able to pay their dues on time. Otherwise, they might even have to shell out 10-15% (annualized) as late fees in some cases. 

Businesses should aim to pay their suppliers on time to keep their business’s credit record clean and maintain good relationships with the sellers. As a customer, if you still fail to pay before the due date, it’s crucial to contact the seller and let them know the reason. It is quite plausible that they will waive off the late penalties if they find the reason genuine.

What are the positives and negatives of trade credit?

Buyers (receiving trade credit)

Sellers (offering trade credit)

Best practices for extending and utilizing trade credit

Buyers

1. Order cautiously It is tempting to place a larger order than required to get lower prices when you do not have to pay instantly. But this can get you into trouble if your inventory doesn’t get sold on time. So, it is best to order conservatively and place the next order only when you are almost out of inventory.
2. Maintain a cash reserve The pandemic has taught us that you can never predict market uncertainties. So, it's always important to stay prepared. The first step towards that is having a cash reserve that allows you to make timely payments even if you don’t meet your sales goal. 
3. Look for smaller businesses It’s easier to get your payment terms favorable to your business when working with smaller vendors. You are more likely to get a higher credit limit and longer payment periods with smaller businesses as compared to enterprises.

Sellers

1. Check your customer’s credit history If a business is not effectively analyzing its customer’s credit history, its receivables are likely to turn 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 assists your business in customer credit checks and faster customer onboarding. It utilizes industry-based best practices to give you 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.

Conclusion

Trade credit is vital for both buyers and sellers. For sellers in the B2B space, it is essential to give credit just to stay relevant in the industry. On the other hand, trade credit is sometimes the only financing option available for buyers, especially small and mid-sized businesses.

FAQs

1) 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.

2) Does trade credit have interest?

Trade credit doesn’t involve any interest if the buyer pays within the agreed due date. In case they fail to do so, the supplier might charge a late payment fee.

3) Is trade credit long or short-term?

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

4) Is trade credit a current liability?

Trade credits fall under the current liabilities category because they are expected to be cleared within one year.

5) 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..

6) How is trade credit a source of finance?

Trade credit allows small businesses to procure goods and services without having to pay upfront, making it a source of finance.