What is Trade Credit?

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.read more or type of credit instrument used. This credit extension is known as the trade credit.

It becomes the source of short-term finance for the customer as they are required to pay the amount at a later date and is one of the helpful tools to grow the business.

How does it Work?

The purpose of trade credit is to extend the credit to the customer by the seller. At the time of 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, it will have to pay the discounted value; otherwise, full payment must be made on the due date.

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Example

For example, 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 term 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 the 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.

Types of Trade Credit

  • 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.read more 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.

Features

Features are as follows:

Why is Trade Credit Important?

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. So, 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. read more since instant outflow is not there.

How to Reduce Costs of Trade Credit?

The cost of the trade credit 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.read more.

Advantages

  • 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.

Disadvantages

  • 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 what is trade credit and its definition. Here we discuss types, features, and examples of a trade credit along with its working and importance. You can learn more about financing from the following articles –

  • Line of CreditCredit FacilityCredit Period ExampleCredit Enhancement Types