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

29 July, 2022
4 min read
Bill Sarda, Chief of Staff, Digital Transformation
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What you'll learn

  • What is trade credit?
  • The direct costs of trade credit
  • What are the positives and negatives of trade credit?
  • Best practices for extending and utilizing trade credit
CONTENT
What is trade credit?
Types of Trade Credit
How do you record trade credit?
The direct costs of trade credit
What are the positives and negatives of trade credit?
Best practices for extending and utilizing trade credit
Conclusion
FAQs
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B2B companies often do business on credit which involves the seller offering a time period to the buyer to make the payment. 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.

What is trade credit?

Trade credit is the short-term credit a seller extends to the buyer for business purposes. The buyer can purchase goods or services within the credit limit from the seller and pay them back before the due date. The period for which the seller offers the credit is called net days, and its typical range is between 30-120 days.

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:

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

  3. Trade acceptance
  4. 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.

  5. Promissory note
  6. 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?

Based on the type of accounting method used by your company (cash accounting method and accrual accounting method), how you record your trade credit varies. Public companies are required to use the accrual method, which means the revenue and expense must be recorded at the time of the transaction.

So, in the case of sellers, trade credits are categorized under the accounts receivable section of the balance sheet, and for buyers, its maintained under the accounts payable section. When the buyer pays the seller, they record it under expense and debit their AP balance, while the seller records it as cash and credits their AR.

Businesses also need to write off some AR as bad debt when customers fail to pay. Such bad debt is categorized under expenses and is credited to the company’s AR.

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?

Most B2B companies offer trade credit to their customers based on their eligibility criteria. But there are many pros and cons of trade credit, both from the perspective of a buyer and seller. Let’s have a look at them.

Buyers (receiving trade credit)

Pros Cons
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)

Pros Cons
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

For businesses, extending trade credit is essential to compete with other companies. On the other hand, for buyers, it is often the only way to do business. Therefore, despite its pitfalls, trade credit is critical for both parties in a transaction. So, let’s look at some best practices that both sellers and buyers must follow to make the most of it.

Buyers

Best practices for extending trade credit

  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

Best practices for utilizing trade credit

  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.

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