BANKING31/08/2022

Trade credit: definition and key takeaways

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Trade credit: definition and key takeawaysTrade credit: definition and key takeawaysTrade credit: definition and key takeaways

Trade credit is zero-interest financing which a company can use to increase sales by facilitating customers’ payment arrangements.

IN A FEW WORDS

Trade creditWhat are trade creditsWhat is trade credit in business


5 min reading

When you buy goods, you usually have to pay the supplier immediately, exchanging your money for a certain product. However, in some cases the company may offer you the option to pay for the goods later on, which is referred to as trade credit.

This is a type of zero-interest financing which a company can use to increase sales by facilitating customers' payment arrangements. Let's find out what trade credit is, how it works and what advantages and disadvantages it presents for customers and vendors.

What are trade credits?

The meaning of trade credit is a payment extension granted to the customer by the selling company, that is, the supplier of the credit. In reality the company provides the customer with a loan but does not charge interest and bears all the costs of the transaction. Credit is the main activity for some financial institutions, whereas it’s a secondary activity for other companies.

Trade credit means a cost for companies offering this service to customers as giving it means they are forgoing a certain amount of money for a certain period of time. Trade credit can also be a risk for companies - there is always the possibility that the customer might not have the money to pay in full on the agreed date or may need more time and pay late.

As a result, companies have to consider using trade credit very carefully, as it exposes the company to costs and risks that could damage its business. To limit costs, companies need to make late payment sustainable and have funds to make up for the initial non-payment. An accurate credit risk assessment is also essential to know which customers to trust.

What is trade credit in business?

Trade credit in business involves a B2B (Business-To-Business) arrangement. Typically, this involves suppliers allowing other companies to buy their goods without paying upfront, instead paying the sum due after 30, 60 or 90 days and without any fees or interest.

Giving trade credit means suppliers can maintain a high and continuous sales flow, while customers can enjoy greater flexibility paying for goods. This allows companies time to resell goods, collect payment from their customers and pay the supplier a few months later.

When it comes to their accounts, public companies use accrual accounting for trade credits. This means revenue generated from sales and expenses incurred are recognised at the time of the transaction, even if payment from the customer has not been made at that time. Private companies usually use cash accounting, reporting revenue when the money is actually received.

Pros and cons of trade credit

Trade credit has advantages and disadvantages for suppliers and customers. It is useful for companies for increasing sales and turnover, however they have to be sure that they can cover expenses and any late or non-payment. Companies that offer trade credit take on all the risks, so they may even risk defaulting if non-performing loans exceed the company's cash capacity.

Companies need to be good at assessing customers they grant trade credit to and determine carefully how much time to allow them to pay. It is possible for companies to use strategies to entice customers not to use trade credit without it affecting sales, for example by giving discounts to those who pay for goods immediately or reducing the amount to be paid for those who pay within 30 days instead of waiting 60 or 90 days.

For customers, the main advantage is that they can buy now and pay later, but without the interest and other costs that are typically associated with loans and financing. However, there are certain risks with trade credit for customers as well. If they can’t sell all the goods they bought using it on time, they may have problems repaying the supplier at the end of trade credit period agreed.

Customer defaults can have knock on consequences for suppliers, making it harder for them to access goods in future. This is because their suppliers in turn may then be concerned about their reliability. Given the potential very heavy penalties involved in case of defaults, it’s crucial for companies that offer or use trade credit in the B2B spere to have a good credit rating.

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