Trade credit is a business-to-business agreement allowing customers to purchase goods from a supplier without paying cash. It typically gives them between 30 and 60 days to pay but it can also be extended to 90 days.
It is a type of commercial financing that allows customers to purchase goods or services and pay the supplier at a later scheduled date, interest-free.
How trade credit works
Trade credit can give buyers an advantage over other forms of financing. It can also allow them to negotiate longer repayment terms. Sellers usually have specific requirements buyers must meet to qualify for trade credit.
Through trade credit, a buyer can receive goods and services before paying for them, which provides them with a revenue stream that can be used to cover the costs of sales. Trade credit can also be used to fund short-term growth. Since it is a type of credit that does not involve interest charges, it can be an effective way to encourage sales. Due to the disadvantages of trade credit, many suppliers offer discounts to encourage early payment. For instance, the supplier may offer a 2 percent discount if a customer pays within 10 days of receiving credit, while the full invoiced amount is due in 30 days with no discount. This is known as 2/10 net 30.
Accounting complexity on trade credit
The buyers and sellers using trade credit are required to account for such transactions because public companies normally use accrual accounting. This type of accounting requires a company to recognise expenses and revenues at the time of the transactions. Trade credit invoicing is another commonly used accounting type, which adds complexity to accrual accounting. This method requires companies to book the expenses and revenue associated with the transactions. Since they do not receive cash immediately following the transaction, they have to account for these assets as accounts receivable.
There is also a possibility of default when it comes to trade credit. With discounts, the company may receive less than it should due to the nature of the agreement. These write-offs are typically required to cover the expenses associated with the transactions.
Who uses trade credit?
Small and medium enterprises usually prefer trade credit due to its flexibility and ability to give them a financial boost without having to go through the laborious process of securing financing. In addition, many financial technology firms now offer point-of-sale financing options to help companies avoid trade credit risks. These types of partnerships allow buyers and sellers to benefit from the lower interest rate on these types of loans.
The nature of trade credit has also led to the development of new financing solutions for sellers. One of these is accounts receivable financing, a type of loan that allows companies to receive capital from their trade credit balances. According to the World Trade Organization, around 80 to 90 percent of global trade is carried out through trade finance. This is why various innovations must be brought to bear in the field of trade credit. One of these is the development of trade credit insurance.
A study by the US Federal Reserve showed that trade credit is becoming more prevalent among small businesses. Around 9 percent of companies were using it as a financing tool as of 2022. Around 60 percent of companies use informal or formal systems for financing their operations, making it the second-most common type of small-business financing after traditional financial institutions. Over 43 percent of all business-to-business transactions rely on trade credit.
Almost every industry has a system allowing businesses to use trade credit or net payment terms. These types of agreements are commonly used in transactions involving multiple services, including cleaning, creative, accounting, landscaping, clothing, and construction.
How to use trade credit for small businesses
Small businesses can benefit from trade credit by spreading their payments and avoiding potential financial shortfalls. In a perfect situation, a company can purchase goods on net terms and sell them quickly to prevent potential shortages. This eliminates the need to spend money on procurement and allows them to increase their sales. One of the most important factors businesses must consider when using trade credit is ensuring that their orders are placed precisely when needed. This allows them to take advantage of the early-payment discount.
Another important factor businesses must consider when using trade credit is ensuring that they do not over-order supplies. Having sufficient cash reserves is also essential when using trade credit. This will allow buyers to easily settle their debts when business is slow.
For buyers, trade credit can be a great alternative to traditional financing. It allows companies to acquire goods or services without immediately paying for them or recognising these expenses.
Unlike other types of financing, trade credit does not require a company to pay until the end of the repayment period. It also eliminates the need for the company to pay interest. Moreover, it allows companies to improve their cash flows by not having to recognise expenses and revenue at the time of the transactions.