Trade Credit: Definition & Overview
Exploring new business strategies is a common occurrence. You want to do what you can to find new ways to grow and expand into the future. There are several ways a business can try to increase sales.
One of the most common is implementing a strategy around trade credit. So how does this work and is there anything important you need to know and understand? Keep reading to learn more!
Table of Contents
- Trade credit works by allowing a customer to purchase goods or services and then pay for them at a later date.
- Trade credit can be an effective way for businesses to finance their short-term growth or maximize cash flow.
- Trade credit financing can help create additional opportunities for financial technology solutions.
- Usually, suppliers face most of the risks and disadvantages since they haven’t received payment for the goods or services sold.
What Is Trade Credit?
Trade credit is a specific type of agreement that allows a customer to purchase their goods without the need to pay cash upfront. It’s common in business-to-business (B2B) and the agreement will outline when the customer will pay the supplier at a later date.
It’s a common occurrence for businesses that implement the use of trade credits and allow for customers to have 30, 60, 90, or up to 120 days to pay off their balance. The transaction gets recorded in an invoice that will outline the specific details of the trade credit, including the total price and payment terms.
You may recognize the concept of trade credit as receiving 0% financing and it helps to increase the sales of a company. This happens by deferring the payment required for the goods or services to a future point in time. Plus, there isn’t a requirement for interest to be paid throughout the repayment period.
Types of Trade Credit
You can usually find a few different types of trade credit depending on the transaction. But, trade credits commonly come in the form of bills payable, promissory notes, and open accounts.
Bills payable has to do with the certain financial instruments that get used by the seller. The buyer then accepts these instruments in return for an agreement to make payment by the outlined expiry date.
A promissory note is more of a formal agreement between the buyer and the seller. The buyer would agree to the outlined terms which would include things like payment date and amount. They would then sign the document and return it to the seller.
Promissory notes can help remove the possibility of problems arising at a later date. However, they’re not actually signed until after the delivery of the goods or services and this is done through a commercial draft.
Essentially, the seller would write a commercial draft outlining what the customer needs to pay and by when. This draft would then get sent to the buyer’s bank, along with any relevant shipping invoices.
An open account is a little bit more of an informal agreement between the buyer and the seller. Basically, the seller would send the goods or services to the seller and include an invoice that would outline payment terms and payment due dates.
Open accounts are usually the most common types of credit offered. So, in this case, the only actual formal credit instrument included is the invoice. Once the transaction of the invoice has taken place, both the buyer and the seller would record the exchange on their accounting books.
Features of Trade Credit Analysis
When looking into granting credit to a buyer, sellers will always try to determine who is likely to pay and who isn’t. There can be several ways for them to determine creditworthiness. Here are some of the most common:
- Credit reports: Looking into credit reports will specify a customer’s payment history and how likely they are to make their payments. Several organizations often sell this information based on the credit strength of firms.
- Financial statements: Sometimes, a seller could ask a buyer to provide their financial statements.
- Banks: If there are any difficulties obtaining some of the information required, banks will often help business customers get what they need in regards to creditworthiness.
- Payment history: Analyzing a customer’s previous payment history with the seller can be a good way to determine if they have paid previous bills when granted credit.
Sellers will also often take into consideration the 5 C’s of credit. There are:
- Capacity: Does the customer have the ability to meet their credit obligations through their operating cash flows?
- Capital: How are the customer’s financial reserves
- Character: Does the customer have a history of willingness to meet their credit obligations?
- Conditions: What are the general economic conditions that would affect the credit?
- Collateral: Should the customer be required to provide collateral in case they default?
Advantages and Disadvantages of Trade Credit
There can be both advantages and disadvantages to trade credit, but it’s important to distinguish these differences for both the buyer and the seller. Advantages for a buyer aren’t always going to be the same for a seller.
One of the biggest advantages of trade credit for a buyer is the simple and easy access to new financing. It’s more affordable compared to other types of financing and there aren’t any extra costs. For example, getting a loan from a bank or financial institution can come with fees and interest rates.
Plus, since the buyer does have to make payment until a later date, receiving a trade credit can help their cash flow. In this case, they would be able to sell goods that they have acquired before having to pay for them.
The primary disadvantage to buyers is that if you don’t make payments on time, there can be high costs associated with not meeting the due date. These can include things like late-payment penalty charges, or even extra interest charges on any outstanding debt.
As well, if payments aren’t made on time, or not made at all, it can negatively impact your business’ credit profile. And, your relationship with the seller will also be negatively impacted.
As a seller, one of the primary advantages that can come from providing trade credit is repeat business. Having strong relationships with buyers will enrage customer loyalty and have them return in the future.
As well, offering trade credits means that buyers might be more likely to make a purchase when there’s no cost associated with the financing. This can lead to higher sales volumes for sellers.
Compared to buyers, sellers are going to have the most disadvantages. The biggest concern is going to be delayed revenue, which can impact businesses that have tight budgets even more. This can affect their ability to cover operating costs, for example.
As well, some buyers just aren’t going to be able to pay off their trade credit which will lead to bad debts. If this happens frequently, there can be more and more risk for the seller when they extend financing.
Trade Credit Instruments
Most of the time, credit gets offered on an open account. In this case, the only type of formal credit instrument utilized is an invoice. The invoice gets sent with the shipment and you would then sign it as evidence the goods have arrived.
There can be instances where you might get asked to sign an IOU or a promissory note. These often get used if there is a large order or if the lender foresees a potential issue in the future. Another trade credit instrument that can get used is a commercial draft. The selling firm would create this document which outlines the specific date and amount you must pay.
Alternative to Trade Credit
One primary alternative to trade credit would be self-insurance. If you choose to self-insure instead, you can add a reserve to your company’s balance sheet. This will help cover potential debt that might occur in a financial year.
Trade credit insurance can be another alternative. You would purchase the trade credit insurance and then have the opportunity to invest any excess capital. For example, it could be an investment into new growth opportunities or the development of new products.
Managing Trade Credit
Trade credit differs from other types of credit since it’s restricted to businesses. As well, trade credit is often unsecured, relatively short-term, and usually offers discounts for payments made early. Managing this effectively usually involves credit managers that oversee the entire process.
The credit managers are part of accounts receivable and they evaluate new and recurring applicants and their creditworthiness. As well, credit managers assist in managing business credit risk for customer accounts. Having these managers in place ensure your trade credit is managed effectively.
Trade credits are a type of financial instrument and can be a good way to obtain business financing for buyers. Trade credit terms will get outlined in an agreement between the buyer and seller. Credit control can be in the form of a promissory note, bills payable, or an open account like an invoice.
Essentially, It’s a B2B trade credit that can allow businesses to make sales to customers through a credit agreement. Details of the trade credit will be listed on the business’s balance sheet. Having good credit management is important for both the buyer and the seller.
Sellers will outline the credit period and will often look into the buyer’s credit rating if they are new customers. This helps ensure that the credit commitment is going to be beneficial for everyone involved.
Trade Credit FAQs
Why Is Trade Credit Short-Term?
Trade credit is short-term because it helps buyers enhance their sales. It can help free up working capital and also finance business growth. Being able to receive payment in a shorter amount of time compared to other types of credit will benefit buyers.
How Is Trade Credit a Source of Finance?
Since it can be an external source of working capital, trade credit is one of the easiest ways for a business to obtain short-term financing. It acts as financing since the buyer doesn’t have to pay the total until a later date.
Is Trade Credit a Financing Strategy?
Trade credit can be a financing strategy, yes. It allows a business to purchase goods or services in exchange for paying the amount back at a later date. Since new businesses can often have difficulty obtaining financing from traditional lenders, trade credit aids in their purchasing power.
How Does Trade Credit Affect Sales and Profits?
Trade credit affects sales and profits by allowing buyers to have more time to evaluate the quality of a product before they purchase it. The trade credit removes the need for unnecessary information to be shared, leading to an increase in profitability and sales.
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