Trade credit is an essential type of financing in sales transactions between vendors and their customers. Suppliers don’t require immediate payment from buyers when they receive the goods or services. Instead, customers are billed on account with invoices, obtaining short-term free seller financing.
What is Trade Credit?
Trade credit is an agreement between two businesses that allows one business (customer) to purchase goods or services from another (supplier) without paying cash up front, and instead pay at a later date. Typically, businesses who do trade credits allow customers to pay within 30, 60, or 90 days, where the payment is then recorded as an invoice. The best part about a trade credit is the lack of interest charged on the delayed payment.
Overview of Trade Credit
Customers don’t automatically receive trade credit terms from their suppliers.
The credit management team uses certain methods of analysis or software reports and predictive analytics tools to decide whether to offer trade credit to customers.
Suppliers vet new customers by viewing their credit report, indicating their capacity to pay, character (willingness to pay), and capital, known as the 3 C’s of credit relating to trade credit decisions. The strength of a buyer’s financial statements, including the balance sheet, and credit history, contribute to this decision.
A company’s credit report, like Dun & Bradstreet products for credit and risk management, rates a buyer’s creditworthiness, including whether they pay bills quickly.
Newer machine learning predictive analytics software tools also help vendors automatically evaluate a customer’s creditworthiness for receiving trade credit terms.
If vendors don’t offer trade credit to customers, the buyers may still purchase goods with COD payment terms (cash on demand) that require payment upon delivery before they can receive the goods.
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Pros and Cons of Trade Credit
Using trade credit has distinct advantages and disadvantages for buyers and sellers.
Trade Credit For Buyers
A trade credit pro for buyers is they improve cash flow and receive free seller financing with trade credit. Customers aren’t required to pay cash immediately upon purchasing goods and services. Trade credit terms may include an early payment discount, reducing the amount buyers will later pay for the invoiced goods or services, increasing profitability.
A trade credit con or disadvantage for buyers is taking the risk of spending before having available cash to pay for their purchases.
Possibly a buyer’s business condition will rapidly decline, or they’ll have uncollectible accounts receivable problems, causing them to be unable to pay their bills when due. At a minimum, not timely paying bills would harm a buyer’s credit rating and result in the supplier cutting off needed product shipments. The customer would experience extreme cash flow problems in the worst case, resulting in insolvency.
Trade Credit For Sellers
A trade credit pro is that sellers can attract and retain more customers by offering trade credit terms to customers. Trade credit helps sellers grow their revenues faster to improve profitability.
A trade credit con or disadvantage is that sellers don’t receive the cash as quickly (or possibly ever) from customers when they invoice buyers for payment using trade credit. As a result, the sellers may need to borrow against their line of credit and incur interest expense to access cash, and sellers assume the trade credit risk of non-payment.
Examples of Trade Credit
Examples of short-term trade credit terms include 2/10 Net 30, which offers a 2% discount if the customer pays the vendor invoice within 10 days of the invoice date. If the customer doesn’t take the early payment discount, the invoice is due for payment within 30 days.
Vendors can elect to charge late payment penalties to customers who don’t pay by the due date if specified in their purchase transaction agreement. Many vendors offer a grace period, waiving late fees for late payments received at a reasonably later date.
The Role of AP Turnover Ratio in Trade Credit
As part of its vetting process for customers, the credit manager can analyze their AP turnover ratio (a trade credit formula) to decide whether they deserve credit terms on sales. The accounts payable turnover ratio evaluates a company’s ability and speed in paying off its trade credit. It measures the number of times that accounts payable is paid off during a year.
What is Trade Credit Accounting?
Trade credit accounting records sales or services revenue as a credit and accounts receivable as a debit. When cash is received for invoices collected by the selling vendor, accounts receivable are reduced by the amount of cash received, and cash is debited instead.
Each business records an estimated allowance for uncollectible accounts and writes off accounts receivable as bad debt against the allowance for doubtful accounts when accounts receivable are considered uncollectible.
Trade credit accounting can be accomplished using either the net method or the gross method. In the gross method of trade credit accounting, record the invoice amount and early payment discount in separate accounts to track total discounts taken by customers or given by vendors. An example of the net method for trade credit accounting (in which the invoice total is reduced by the discount) follows.
What is the Net Method for Trade Credit Accounting with Discounts?
Record the invoice balance less discount as one net amount. The customer records a credit purchase and accounts payable. The vendor records the credit sale and accounts receivable.
$500 – $10 discount = $490 net amount recorded
This example shows the transactions, often automated using accounting software.
To record a purchase when the customer receives the goods:
Accounts payable: $490
To pay the invoice included in the accounts payable balance early:
Accounts payable: $490
If the company doesn’t pay early, then the entry is:
Accounts payable: $490
Purchase Discounts: $10
Purchase discounts is a contra account to purchases but increase purchases if not paid early.
What is Trade Credit Insurance?
Trade credit insurance is a business insurance policy that protects sellers from uncollectible accounts receivable (bad debt) caused by customers going bankrupt, defaults, political risks, and other specified factors.
What are Credit Put Options for Trade Credit?
Credit put options are an alternative risk management solution that publicly-traded companies and larger private companies use for protection against trade credit losses from insolvent customers.
UPS Trade Credit Protection Services offers credit put options in partnership with financial institutions for terms ranging from six months to three years in amounts covering $500 thousand to $100 million.
The business with credit put options can sell the receivables from a bankrupt customer back to the bank, receiving 100% coverage of the insolvency loss without a deductible or co-insurance.
What are Trade Credit Services?
Trade credit services are outsourced services, including accounts receivable collection of domestic and international trade sales invoices. Trade credit services may include helping companies with letters of credit documents needed for export sales transactions in trade finance.
Other trade credit services are managed software services for automatically evaluating and identifying potential customers that would be good credit risks for extending trade credit.
Collection agencies may receive a percentage of the balance collected instead of a fixed fee or hourly rate for invoice collection services.
Is Trade Credit a Loan?
Yes. Trade credit can be considered an interest-free loan from the seller (lender) to the buyer (borrower) for the purchase of goods or services. Trade credit is the cheapest form of financing that a business receives as the buyer in a business transaction.
Is Trade Credit Short-Term?
Yes. Trade credit is short-term financing at zero interest, rather than long-term. Credit terms extended to a customer generally range from 30 days to 90 days, with a specific due date indicated on the invoice that matches the terms of the purchase order.
Importance and Benefits of Trade Credit
Trade credit is a very important short-term financing tool that helps seller businesses grow their revenues by meeting customer expectations to delay payment until billed. The cost of trade credit as providers to customers is balanced by trade credit extended to these selling vendors by their vendors when they buy goods or services in business-to-business (B2B) transactions.
Startups and early-stage small businesses have limited financing options if they don’t receive venture capital. They may not yet have access to business financing with credit lines from traditional lenders like financial institutions, including banks.
Trade credit improves a buyer’s cash flow and liquidity because they have some time to complete their own cash conversion cycle instead of immediately using up their credit card balances and reaching their credit limits. Of course, they still need to be qualified to receive trade credit rather than COD payment terms.
For larger companies, as buyers, the stakes are even higher for this type of credit because of the magnitude of their purchases. They save a sizable amount of interest costs with trade credit as interest-free vendor financing.
For better cash flow from working capital balance changes, businesses need to optimize their accounts payable and accounts receivable balances (aged by invoice due date) through the timing of payments to suppliers and collections from customers. Receiving trade credit from vendors helps them accomplish this essential goal.