Trade Credit Definition
Trade credit refers to the credit that is extended to the buyer of the goods or services from its supplier; in other words, with trade credit accounts, the 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, it might allow the customer to pay the amount in exchange for such goods and services after a certain period. The 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. This credit extension is known as the trade credit.
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Trade Credit Explained
Trade credit is a financial arrangement wherein a business buys goods or services on credit from its suppliers. This form of credit is an integral component of the broader spectrum of working capital management. Essentially, it allows a company to acquire the necessary inventory or services required for operations without an immediate exchange of cash.
In this scenario, the buyer and the seller agree upon specific credit terms, such as the duration within which the payment must be made. Commonly expressed as “net” payment terms, like “Net 30” or “Net 60,” these indicate the number of days the buyer has to settle the invoice. Trade credit offers businesses flexibility and can serve as a crucial tool for maintaining cash flow.
Moreover, it nurtures strong relationships between buyers and suppliers, fostering a sense of trust and collaboration. While advantageous, it is essential for businesses to manage trade credit insurance responsibly, ensuring timely payments to sustain a positive credit relationship. Failure to uphold these terms may lead to strained relations and, in severe cases, impact the creditworthiness of the purchasing entity.
The purpose of trade credit is to extend the credit to the customer by the seller. At the time of the sale of goods and services, the seller allows the customer to make the payment later rather than paying it instantly at the time of sale. The parties agree according to their type.
Generally, the seller allows the cash discount to the buyer if the latter makes the payment before the due date and within a specific period from such sale. If the customer makes the payment before the due date, they will have to pay the discounted value; otherwise, full payment must be made on the due date.
Let us understand the different types of trade credit accounts through the discussion below.
- Trade Acceptance – Under this type, formal documentation is made between the buyer and the seller for accepting the terms of the sale. Initially, the seller draws an official draft document before shipping the goods. If the buyer accepts and signs the draft, then it clarifies its acceptance, and the draft becomes trade acceptance. 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 defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date. is the formal document to be signed by the buyer. It is usually issued for extending an open account that is already in existence before the due date.
Let us understand the features of this concept through the points below. It shall help us understand the intricacies of the concept and its related factors.
- It is a form of 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 agreed-upon terms between the parties.
- There are three trade credit types: trade acceptance, open account, and promissory note.
- Businesses can optimize cash flow as they can delay payment while still maintaining the necessary inventory or services required for seamless operations.
- It provides businesses with a degree of financial flexibility, allowing them to manage their cash resources more effectively by leveraging credit for short-term needs.
- Trade credit accounts can serve as a risk mitigation tool, particularly in industries with fluctuating demand or uncertain economic conditions, providing a buffer against unforeseen financial challenges.
Let us understand the practical application of trade credit insurance and its related concepts through the examples below.
Goods are sold on credit by the supplier to one of its customers, amounting to $20,000. The credit was granted as per the term of sale with 3/15 net 40. Now, according to terms, a $20,000 trade credit is given to the customer for 40 days from the date of the invoice issued.
However, as per the terms 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 a 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.
India has been on the rise economically and as a global power to be reckoned with. In October 2023, Allianz Trade published a report that showed a 16 percent average growth in the trade credit insurance space in India between 2018-2023.
It also forecasted that this industry in India is set to grow at an average rate of 20% as a part of the economy’s growth from the COVID-19 pandemic that slowed down their overall growth. With this, the report also states that its economic growth will outperform that of its Asian peers.
How to Reduce Its Costs?
The cost of the trade credit accounts can be reduced by making an early payment. 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, 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..
Let us understand the importance of trade credit insurance and other related factors of the concept through the points below.
- 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.
- It is one of the simplest and easiest sources of short-term finance that businesses can avail themselves of. Also, this less pressure is put on the company’s cash flowCash 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.
- It allows businesses to maintain healthy cash flow by deferring payment for goods or services, ensuring operational continuity without immediate financial strain.
- It plays a pivotal role in working capital management, enabling companies to efficiently allocate resources, procure necessary inventory, and meet operational needs without tying up substantial capital.
- Trade credit fosters positive relationships with suppliers, as timely payments build trust and reliability. This, in turn, can lead to better terms, discounts
Let us understand d the advantages of maintaining trade credit accounts through the discussion below.
- Trade credit is one of the helpful tools to grow the business as it is short-term finance, which the company can avail of without incurring the extra costs.
- In this case, as the payment is not required to be done immediately, it effectively puts less pressure on the company’s cash flow.
- Protection is available to the supplier by the late payment legislation.
Let us also shed a bit of light onto the other side of the concept as well through the disadvantages discussed below.
- One of the prominent disadvantages of trade credit for the customer could be the loss of the discount, which could be availed in case the payment is made instantly to the supplier.
- The trade-credit facility might deteriorate the relationship with the supplier or lose the supplier if it is unable to adhere to its terms.
- From the supplier’s point of view, the trade credit delays the cash inflow 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 Trade Credit and its definition. Here, we discuss types, features, and examples of a trade credit and its importance. You can learn more about financing from the following articles –