Trade Credit: Meaning, Pros and Cons in Business

trade credit
trade credit

It’s difficult to conceive of a world in which businesses operate without credit. Working capital and cash flow are two of the most crucial parts of running a successful business or trade operation in the modern world (B2B).

Customers, particularly those in the B2B (Business to Business) sector, prefer the ability to buy goods and services on credit rather than having to pay cash upfront.

As a result, the role of Trade Credit enters the picture and becomes an essential component of business-to-business transactions.

This article explains exactly what “Trade Credit” is and how crucial it is during business-to-business (B2B) sales transactions between two parties or firms.

Trade Credit – Definition

A Trade Credit, also known as a Tradeline or business credit, is a credit facility that is made available to the clients of a supplier of products or services in exchange for the purchase of any goods or services from that supplier without the requirement of making an upfront cash payment.

In other words, a “trade credit” is an arrangement or agreement between buyers and sellers that give the buyer the freedom to purchase products or services without paying cash upfront to the sellers of those goods or services. This arrangement or agreement is known as a “Trade Credit.”

However, the payment for such goods or services must be made to the supplier at a future date that has been agreed upon in advance. This date typically falls between 7, 14, 21, or 30, 45, 60, or 90 days after the date of purchase (or the date on which the goods were received). Still, it can be longer or shorter depending on what has been mutually agreed upon or negotiated.

Despite this, some businesses, like Goldsmith, give their clients access to loans for even extended periods of time. It’s also possible that the companies will provide a discount for early payments made within a particular window of time prior to the due date.

Key Points –

  • Trade credit is a form of business financing that does not require the payment of interest to the provider of the goods or services financed and does not involve the participation of lending institutions.
  • It operates on the same principle as the “buy now, pay later” model, which makes it easier for companies to keep their cash flow steady.
  • The trade credit provided by the suppliers is marked as “Account receivables” in the balance sheet of the supplier firm, whereas, in the balance sheet of the buyer firm, it is denoted as “Account payables.”

Credit Period –

The length of credit periods completely varies from business to business or from consumer to customer. The following considerations are taken into account when determining the length of any customer or buyer’s credit period by the supplier.

  • The industry or sector that the goods or services fall under is by far the most important criterion that decides the credit period that will be given. Therefore, this method will shorten the credit period if there is a great demand for products or services on the market.
  • When selecting a loan duration, the creditworthiness of the purchaser is another crucial consideration to take into account. If the customer has an excellent credit history, the suppliers won’t consider extending the credit period they offer to the consumer.
  • If there is a lower demand for products and the product’s value is high, suppliers are required to offer relatively longer credit terms to the customers who are purchasing those products.

For instance, given the high level of consumer interest in their goods, fast-moving consumer goods (FMCG) corporations such as HUL and P&G do not give trade credit to the C&F retailers who sell their items. Therefore, they are not required to grant credit; retailers and shopkeepers must pay cash in advance to purchase the items.

As a result, we are able to conclude that the length of time that a business is granted trade credit (the credit term) also depends not only on the industry but also on demand for items in the market and, of course, the expiration date of the product at the same time.

Trade Credit – Importance in Business

Whenever there were two parties involved in a domestic or local transaction, there was always a hurry to boost the sales and margin or profit that the provider made.

The local market is experiencing a daily increase in the level of competition amongst the many suppliers of generic items. As a result, it has become difficult to keep a customer for an extended period of time. Customers not only require that they be given a credit period, but they also want that the products to be sold to them at the most favorable prices.

As a result, extending trade credit is now required if a company wishes to continue operating successfully throughout an extended period.

If, on the other hand, we examine the situation from the point of view of the buyer, we find that trade credit has been an essential instrument for managing cash flow and the inventory of various commodities at no additional cost.

In addition to this, they are granted a further period during which they might sell the things to additional customers or consumers on a cash basis. Therefore, there is no requirement for purchasers to invest more dollars in order to manage inventory.

Due to the high degree of competition and profit margin in certain industries, such as the pharmaceutical industry, the suppliers of medications or corporations are required to grant trade credit to their distributors or retailers. This is the case in the pharmaceutical industry. This is due to the fact that there are a great number of drug manufacturing firms; nonetheless, marketing is the component of this business that is of greater significance. Because of this, corporations are obligated to make credit facilities available for the distribution of pharmaceuticals.

Cost of Trade Credit –

Since there is no participation from any banks or other lending organizations to give a trade credit, the phrase “no involvement” is appropriate. These credit facilities are made available to the supplier’s frequent customers as part of the supplier’s efforts to maintain and expand their client base.

Therefore, using trade credit does not impose any expense (zero cost) on the purchasers of the products or services; but it is possible that these purchasers will not benefit from any discount (cash discount) that the vendors provide.

On the other hand, if buyers fail to make payment on the due date, some sellers might also charge some interest (late payment charges), but this varies from case to case. Some suppliers typically offer a discount if the buyer pays the dues within a certain time period. If the buyer pays the dues within a specific time period.

For illustration’s sake, let’s say a corporation offers trade credit at a rate of 2/10, net 30 days. This means that the buyer is expected to pay the bills before the 30-day grace period has passed, and he will receive a discount of 2% if he makes payment within 10 days.

Pros of Trade Credit –

As was already mentioned, the purchasers are the primary beneficiaries of the benefits associated with trade credit. The following are some of the most significant advantages:

Buyers –

  • Buyers don’t need to invest extra funds in inventory management.
  • Positive cash flow without any additional effort is achieved with Trade Credit.
  • The buyers can buy the goods or services without paying upfront cash.
  • The buyers don’t need to arrange more funds to expand the business.

Supplier –

  • It facilitates sales and the overall turnover of the company.
  • Suppliers have the opportunity to build strong relationships with customers.
  • A supplier can retain their customers for the long term.
  • A supplier might sell their products at a higher price to their loyal customers by offering a credit facility.

Cons of Trade Credit –

Buyers –

  • Buyers usually purchase goods at higher rates because they miss the opportunity of cash discounts.
  • Buyers might have to pay extra money if they don’t pay the dues on time.
  • Buyers are sometimes bound to purchase goods or services from particular sellers only.
  • Buyers can’t negotiate rates of products with sellers as much as they can.

Supplier –

  • Bad debts and delayed payments are a few of the significant trade disadvantages of credit for sellers.
  • An increased number of bad debts can lead to even a loss to the sellers.
  • Trade credit can negatively affect the cash inflow for businesses if the receivables are not paid off on time.
  • Suppliers not only always risk non-payment but also lose their customers forever due to arrears.
  • The supplier’s sales may be compromised because of unpaid bills, leading to a cash crunch for small businesses.

How to analyze the credit of a buyer?

When defining the length of a trade credit period, doing a credit analysis is essential, regardless of whether you are a supplier, firm, or salesperson working in a company.

You can estimate the creditworthiness of any buyer or firm by applying the following evaluation criteria to their financial history.

1) Financial Statement

The buyer’s firm’s true situation can be discerned from the company’s financial statement or firms being purchased. Therefore, before delivering items or extending loans, you should conduct an in-depth analysis of the company’s financial accounts.

2) Credit History

By looking at their past credit history with other companies, you might better understand purchasers’ nature, character, and attitude. You can determine whether or not the buyer is loyal by gathering feedback from other providers in the same position as you.

3) Banks –

The financial institutions could also be useful in acquiring information regarding the companies’ previous credit histories. When determining the buyer’s creditworthiness, you should just look at the comments provided by the buyer’s bank.

4) 5C Principle

The 5C approach will assist you in rapidly assessing the trustworthiness of the prospective purchaser.

  1. Character: The buyer’s character is more important than anything else because if the buyer’s intention is not to pay the due, what else can allow him to do so?
  2. Capacity: The buyer’s capacity is also important because if he intends to pay but is not capable enough, what can anyone do in this matter?
  3. Capital: If a buyer has enough capital or reserve funds, he can meet his obligations.
  4. Collateral: If the buyer did not purchase the products against collateral, then the seller has the right to recoup their money from the collateral. However, if the buyer did not purchase the goods against collateral, then the seller does not have this right.
  5. Condition: The current state the purchasers are in is of utmost significance. Even if he has successfully completed all of the qualifications listed above, his current state should be the deciding factor in whether or not he receives credit.

Conclusion

In the real world, it is extremely difficult for a company to thrive without access to financing. Therefore, the provision of trade credit becomes an essential component of every kind of business. However, not only does it make things easier for the sellers of goods, but it also makes things easier for the people who are buying them.

There are many examples of trade credit these days, and even the most successful multinational corporations use various credit facilities in the market.

In a nutshell, it is a zero financing short-term credit facility for the purchasers, which lets them manage inventories at no additional cost and eliminates any potential financing problems. Even a large retailer like Walmart uses trade credit to manage their inventory, and the suppliers won’t be paid until after all of their products have been moved off the shelves.

References:

  1. https://www.investopedia.com/terms/t/trade-credit.asp#:~:text=Trade%20credit%20is%20a%20business,at%20a%20later%20scheduled%20date.
  2. https://corporatefinanceinstitute.com/resources/knowledge/other/what-is-trade-credit/
  3. https://books.google.com/books?id=zg3tuhkjMK0C&pg=PA20&dq=trade+credit&hl=en&newbks=1&newbks_redir=1&sa=X&ved=2ahUKEwjCqsCd46rwAhUZcCsKHS57ATwQ6AEwAXoECAUQAg
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