What is Trade Credit?
Trade credit refers to the credit which is extended to the buyer of the goods or services from its supplier or in other words customer is allowed to purchase the goods or services on account from the supplier without paying the money upfront and the due money can be paid at a later date as mentioned in the term of sale between the parties involved.
When the seller sells the goods or provides the services to the customer, then it might allow the customer to pay the amount in exchange for such goods and services after a certain period. This credit extended is known as the trade credit. Period for which credit is extended is mentioned in terms of a sale, which is entered into by the parties involved, along with details of cash discountCash DiscountCash discounts are direct incentives and discounts provided by any company to their customers in exchange for paying their bills on time or before the due date. This is a common practice, and the discount may differ from one company to the next depending on the terms and conditions. or type of credit instrument used.
It becomes the source of the short term finance for the customer as they are required to pay the amount at a later date and is one of the helpful tools to grow the business.
How does it Work?
The purpose of trade credit is to extend the credit to the customer by the seller. At the time of sale of goods and services, the seller allows the customer to make the payment at a later date rather than paying it instantly at the time of sale. The agreement is entered into by the parties according to their type.
Generally, the seller allows the cash discount to the buyer if the later makes the payment before the due date and within a specific period from such sale. Now, if the customer makes the payment before the due date, then it will have to pay the discounted value; otherwise, full payment is required to be made on the due date.
For example, goods are sold on credit by the supplier to one of its customers, amounting to $20,000. The credit granted as per the term of sale with the terms of 3/15 net 40. Now, according to terms, $20,000 trade credit is given to the customer for 40 days from the date of the invoice issued.
However as per the term of sale if the payment is made by the customer to the supplier within 15 days from the date when the invoice was issued to the customer, then the cash discount of 3% will be given to the customer, i.e., $600 ($20,000 * 3%) and the customer is required to make payment of $19,400.
Types of Trade Credit
- Trade Acceptance – Under this type, formal documentation is made between the buyer and the seller for accepting the terms of the sale. Initially, an official draft document is drawn by the seller before shipping the goods. If the buyer accepts and signs the draft, then it clarified its acceptance, and the draft becomes trade acceptance. Now, after the acceptance, the goods will be shipped to the customer by the seller.
- Open Account – In the case of an open account, there is no formal agreement between the parties.
- Promissory Note – Promissory NotePromissory NoteA promissory note is a negotiable instrument that represents the debtor's or the writer's (the maker's) written consent to pay a promised sum to the creditor (the payee) on a specified date. is the formal document that is to be signed by the buyer and is usually issued for extending an open account, which is already in existence before the due date of the same.
Features are as follows:
- It is a form of the short term finance extended by the sellerFinance Extended By The SellerSeller financing is an agreement between the buyer and seller of the real estate in which the seller manages the mortgage process and provides a loan; the buyer makes an initial down payment of the principal amount and pays the remaining amount through monthly payments with interest. to the buyer of goods or services.
- The goods or services are delivered instantly, but the payment is required to be made at a later stage.
- The payment date, discount for the early payment, and other transactions will depend on the terms of sale agreed between the parties.
- There are mainly three types of trade credit, which include trade acceptance, open account, and promissory note.
Why is Trade Credit Important?
It is an essential aspect for the customer as it gives them a certain period to make the payment to the supplier rather than paying it instantly. So, it is one of the simplest and easiest sources of the short term finance that can be availed by the businesses. Also, this less amount of pressure is put on the cash flow of the companyCash Flow Of The CompanyCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. since instant outflow is not there.
How to Reduce Costs of Trade Credit?
The cost of the trade credit can be reduced by making the early payment. As if the payment is made within the discount period allowed, then the customer will be given a discount on the total amount. If this discount facility is not availed, then it is an evident loss of the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven..
- Trade credit is one of the helpful tools to grow the business as it is short term finance, which the company can avail without incurring the extra costs.
- In this case, as the payment is not required to be done immediately, so it effectively puts less amount of pressure on the cash flow of the company.
- Protection is available to the supplier by the late payment legislation.
- One of the prominent disadvantages of trade credit for the customer could be loss of the discount, which could be availed in case the payment is made instantly to the supplier.
- The trade-credit facility might result in deterioration of the relationship with the supplier or loss of the supplier if it is not able to adhere to its terms.
- From the point of view of the supplier, the trade credit with delay the inflow of the cash and thereby will lead to the loss of the opportunity cost. Also, there is no guarantee that the customer will adhere to the terms and may pay later than the time granted.
This article has been a guide to what is trade credit and its definition. Here we discuss types, features, and examples of a trade credit along with its working and importance. You can learn more about financing from the following articles –