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A trade credit is a business-to-business (B2B) transaction in which one business is able to procure goods or services from the other without immediately paying for them. It’s called a trade credit because when a seller allows a buyer to pay for goods or services at a later date, it is extending credit to the buyer.
Trade credit can be a great tool for a small business: It can free up cash flow and grow a company’s assets. However, there are some drawbacks, including a short financing window and potentially high interest if the borrower needs to extend that window.
Here’s what every small business should know about trade credit.
Key Points
• Trade credit is a short-term financing arrangement in which a supplier allows a business to purchase goods or services and pay at a later date, typically within 30 to 120 days.
• It helps businesses maintain cash flow by deferring payments, allowing them to use available funds for other operational needs.
• Trade credit generally does not carry interest if paid within the agreed-upon term, making it a cost-effective financing option.
• Strong trade credit terms can enhance relationships with suppliers, encouraging future collaborations.
• Delayed payments may result in penalties or strained relationships with suppliers.
How Does Trade Credit Work?
If you’ve been wondering what trade credit is, it’s a formal name for an agreement between two companies in which one company is able to purchase goods from the other without paying any cash until an agreed-upon date. You can think of trade credit the same way as 0% financing, but with shorter terms. Sometimes trade credit financing is also referred to as vendor financing.
Sellers that grant their customers trade credit generally give them anywhere between 30 and 120 days to pay for the goods or services they received on credit. The range, however, can be higher or lower depending on the industry and individual seller.
Often, the seller will offer the buyer a discount if it settles its account earlier than the balance due date. If the seller does offer a discount, the terms of the trade credit sale are usually written in specific format that will indicate this option. For example, if the seller offers a 5% discount if the invoice is paid within 20 days but is willing to give the buyer a maximum of 45 days to pay the invoice, that agreement would be written as:
5/20, net 45.
If the buyer is unable to pay its invoice within the set time period (which is 45 days in the above example), the vendor will typically charge interest. If that happens, trade credit is no longer an interest-free form of financing.
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Common Terms
Common terms used in trade credit financing include:
• Net terms: This specifies the number of days the buyer has to pay the invoice, such as “Net 30” or “Net 60,” meaning payment is due within 30 or 60 days, respectively.
• Discount terms: This refers to a discount for early payment, like “2/10, Net 30,” which means a 2% discount is available if the cost is paid within 10 days.
• Credit limit: This is the maximum amount a supplier allows a buyer to purchase on credit at one time.
• Invoice: This means a detailed bill issued by the supplier outlining goods or services provided and the payment due.
• Grace period: This refers to the extra time the suppliers allow beyond the due date for the buyer to settle the account without incurring penalties.
Typical Payment Periods and Discounts
Both payment periods and discounts can vary depending on factors that include the industry the companies work in, the supplier’s policies, and the buyer’s creditworthiness. But here are some typical numbers.
Payment periods are most often for 30, 60, 90, or 120 days. While discounts may be even more variable, one commonly cited is 2/10 net 30. “Net 30” means, as we’ve discussed, that you have 30 days until your term is up, while “2/10” indicates if you pay within 10 days, you’ll get a 2% discount.
How Trade Credit Affects Cash Flow
Trade credit can be extremely helpful to buyers by allowing them more flexibility in managing their cash flow. With the benefit of trade credit, a company may be able to pay for its goods using the revenue from its sales, rather than needing upfront cash to pay off its products. It could use its available cash for operational needs rather than paying immediately for the seller’s goods.
Types of Trade Credit
The three main types of trade credit include:
1. Open Account: The most common form, in which the supplier delivers goods or services and the buyer agrees to pay by a specified date. The term is usually 30 to 120 days later.
2. Promissory Note: A formal written agreement in which the buyer promises to pay the supplier by a certain date. It’s often used when open accounts are not available.
3. Trade Acceptance: The buyer signs a formal agreement accepting the supplier’s terms and acknowledging its own obligation to pay at a future date. Trade acceptance is sometimes used for larger or international transactions.
Recommended: What Is a Promissory Note?
Who Uses Trade Credit?
Some businesses are more likely to use trade credit than others. Business trade credit is very common in the B2B ecosystem, for example.
Whether trade credit is something that you may be able to use will depend on a number of factors, including the industry you work in and the size and age of your business.
Small and Mid-Sized Businesses
Typically, trade credit is often used by small and mid-sized companies. New businesses especially may find it challenging to access traditional funding, and even more so if they’re in a hurry — trying to deal with an irregular cash flow, for example. Trade credit can provide a way for these businesses to get more flexibility in paying for their needs and help them build positive relationships with their suppliers. Larger companies with more established credentials may find it easier to get the funding they need without using trade credit.
Industries That Commonly Rely on Trade Credit
In certain industries, trade credit is used frequently. These industries include the following:
• Automotive: Garages, auto dealers, and related businesses
• Construction: Contractors and construction companies
• Hospitality: Hotels, bars, restaurants, and event spaces
• Manufacturing: Factories of all kinds
• Retail: Businesses that sell goods of all kinds
Pros and Cons of Trade Credit
Like any kind of financing, including loans, lines of credit, and equipment financing, trade credit offers both benefits and drawbacks to both parties involved in the transaction. Here are some of the most notable.
Pros and Cons of Trade Credit for Buyers
Advantages of trade credit for buyers include:
• Frees up cash: Because payment is not due until later, trade credit improves the cash flow of businesses, enabling them to sell goods they acquired without having to pay for those goods until a future date. Trade credit financing can be a good option for companies expanding into a new market or businesses that have seasonal peaks and dips.
• Possible discount: Depending on the trade credit agreement, if the buyer pays the invoice within a certain amount of time, it may receive a discount on the goods or services it purchased.
• 0% interest: The cost of capital can be a burden on some small businesses. If the buyer can settle the invoice within the agreed-upon time frame, there is no interest charged on this type of financing.
Disadvantages of using trade credit for buyers include:
• Short payment period: The length of the trade credit payment term varies, but it’s often 120 days or less, which is shorter than the terms for most types of small business loans. For a growing small business, this may not be enough time. Companies that need a longer repayment period may want to look into other types of debt instruments.
• It’s easy to overcommit: With discounts and wholesale prices, it can be tempting to buy too much of a particular good. Not only does this create excess inventory, but it also translates to a bigger debt obligation.
• Possible penalties for late payments: Depending on the trade credit agreement, there may be negative consequences for late payments, such as interest charges or a fine. In addition, the company might report your late payment to the credit bureaus, which could damage your business’s credit score. Of course, this is likely to be true of startup business loans, too.
Recommended: Getting a Cash Flow Loan for Your Small Business
Pros and Cons of Trade Credit for Sellers
Some positive aspects of using trade credit for sellers include:
• Beat out competitors: Companies offering trade credit may be able to gain an advantage over industry peers that don’t offer trade credit. Because it can be difficult for some small businesses to get a bank loan, they may seek out suppliers offering trade credit.
• Develop a strong relationship with clients: Offering trade credit often increases customer satisfaction, which can lead to customer loyalty and repeat business.
• Increase sales: Trade credits are still sales even if payment is delayed. Trade credit can also encourage customers to purchase in higher volumes, since there is no cost to the financing. Therefore, a trade credit can provide the opportunity for growth and expansion.
Negatives of trade credit for sellers include:
• Delayed revenue: If your business has plenty of cash, this may not be an issue. However, if budgets are tight, delayed revenue could make it difficult to cover your operating costs.
• Risk of buyer default: Sometimes customers are unable to pay their debts. Depending on the trade credit agreement, there may be little to nothing the seller can do other than sell the debt to a collection agency at a fraction of the cost of the goods provided.
• Less profit with early payment discounts: If the seller offers a discount for early payment, it will earn less on the sale than it otherwise would.
Recommended: Understanding Business Liabilities
Trade Credit Accounting
Trade credit needs to be accounted for by both buyers and sellers. The process, however, will vary depending on the company’s accounting method — specifically, whether it uses accrual or cash accounting.
With accrual accounting (which is used by all public companies), revenue and expenses are recorded at the moment of transaction, not when money actually changes hands. With cash accounting, in contrast, a business records transactions at the time payments are made.
A seller that offers trade credits and uses accrual accounting can face some complexities if the buyer ends up paying early and getting a discount or defaulting (and never paying). In these cases, the amount received doesn’t match the company’s account receivables and the difference becomes an account receivable write-off, or liability that must get expensed.
Trade Credit Instruments
Typically, the only formal document used for trade credit agreements is the invoice, which is sent with the goods and which the customer signs as evidence that the goods have been received. If the seller doubts the buyer’s ability to pay in the allotted time, however, there are credit instruments it can use to guarantee payment.
Promissory Note
A promissory note, or IOU, is a legal document in which the borrower agrees to pay the lender a certain amount by a set date. While it’s usually used for repaying borrowed money, it can also be used to pay for goods or services.
Commercial Draft
One hitch with a promissory note is that it is typically signed after delivery of the goods. If a seller wants to get a credit commitment from a buyer before the goods are delivered, it may want to use a commercial draft.
A commercial draft typically specifies what amount needs to be paid by what date. It is then sent to the buyer’s bank along with the shipping invoices. The bank then asks the buyer to sign the draft before turning over the invoices. After that, the goods are shipped to the buyer.
Banker’s Acceptance
In some cases, a seller might go even further than a commercial draft and require that the bank pay for the goods and then collect the money from the customer. If the bank agrees to do this, it must put the agreement in writing — which is called a banker’s acceptance. It means that the banker accepts responsibility for payment.
Letter of Credit
Letters of credit are financial instruments frequently used in international transactions,. While they’re not commonly used to guarantee trade credit payment, a seller could ask a buyer to have its bank issue a letter of credit as additional assurance of payment. When you request a letter of credit from your bank, after ensuring that you have sufficient funds, the bank may agree (for a fee) to pay your suppliers for their goods and/or services if you default — as long as specified conditions are met. The letter of credit helps assure the seller that if you can’t pay, it will still be able to get its money from the bank.
Trade Credit Trends
Trade credit is widely used worldwide. In fact, the World Trade Organization estimates that 80% to 90% of all world trade relies on trade credit in some capacity. It’s so widespread that it’s given rise to a type of financing called accounts receivable financing (also known as invoice financing).
With invoice financing, a company that offers trade credit can get a loan based on its outstanding invoices, effectively enabling it to get paid early. When it receives payments from its customers, it gives that money (plus a fee) to the financing company.
Recommended: Understanding Business Liabilities
The Takeaway
Trade credit in business is a common practice that occurs when two companies agree that one will purchase goods or services from the other but won’t pay until a later date.
Essentially an interest-free loan, trade credit can be particularly rewarding for young businesses as well as for seasonal businesses that may find themselves occasionally strapped for cash. A key drawback of trade credit, however, is that the buyer is generally expected to pay the invoice relatively quickly, sometimes within a month or two. For many small businesses, that may not be enough time, and they might be better served by getting a small business loan.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is an example of trade credit?
If you’ve been wondering, “What is trade credit?” here’s an example. Let’s say a restaurant offers kobe beef on its menu and gets its beef from a food supplier in Japan. The supplier offers the restaurant a 5/30, net 60 trade. This means that the restaurant has 60 days to pay for a shipment of beef. If it pays the invoice within 30 days, however, it will receive a 5% discount on the purchase price.
Are there any benefits to trade credit?
Yes, benefits of trade credit can include interest-free financing for buyers, improved cash flow for buyers, increased sales volumes for suppliers, and potentially strong relationships and customer loyalty for suppliers.
When do businesses typically use trade credit?
Businesses use trade credit when they do not have the capital on hand to make a purchase or they need to temporarily free up cash for other expenses. Trade credit is also a good option for young businesses that may not qualify for other forms of business financing.
How does trade credit affect business relationships?
Trade credit can help build business relationships. Suppliers may be able to sell more to buyers when they offer trade credit, and buyers may feel loyal to suppliers with whom they have trade credit agreements. If the trade credit obligtations are met, the relationship between the parties will likely be a positive one.
Is trade credit considered a loan?
Essentially trade credit functions like a very short-term no-interest loan between two businesses. However, not all accounting systems treat trade credit in exactly the same way as a loan.
Photo credit: iStock/Hiraman
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