Trade credit

Trade credit is an arrangement where a business can purchase goods or services from a supplier and pay for them at a later date.
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Updated: May 31, 2024

3 key takeaways

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  • Trade credit allows businesses to acquire goods or services without immediate payment, aiding cash flow management.
  • It is a short-term financing tool commonly used in business-to-business transactions.
  • Effective management of trade credit can improve supplier relationships and financial stability.

What is trade credit?

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Trade credit is a financial arrangement in which a supplier allows a business to purchase goods or services and defer payment until a later date, typically ranging from 30 to 90 days. This type of credit is a common practice in business-to-business transactions and serves as a form of short-term financing that helps businesses manage their cash flow and working capital needs.

Trade credit provides businesses with the flexibility to obtain the necessary inventory or services without the immediate need for cash, allowing them to use their resources more effectively and maintain smooth operations. It also fosters trust and strengthens relationships between buyers and suppliers.

How trade credit works

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The process of trade credit typically involves the following steps:

  • Agreement: The buyer and supplier agree on the terms of the trade credit, including the credit period, payment terms, and any applicable discounts or penalties.
  • Purchase: The buyer places an order for goods or services, and the supplier delivers them as agreed.
  • Invoice: The supplier issues an invoice to the buyer, detailing the amount owed and the payment due date.
  • Payment: The buyer pays the invoice within the agreed-upon credit period, taking advantage of any early payment discounts if applicable.

Example: A business orders $5,000 worth of inventory from a supplier with a 60-day credit term. The supplier delivers the goods and issues an invoice for $5,000, which the business must pay within 60 days.

Benefits of trade credit

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Trade credit offers several advantages for both buyers and suppliers:

  • For Buyers:
    • Cash Flow Management: Deferring payment allows businesses to better manage their cash flow, ensuring they have sufficient funds for other operational needs.
    • Increased Purchasing Power: Businesses can acquire more goods or services than they could if immediate payment were required.
    • Building Credit History: Regular use and timely repayment of trade credit can help businesses establish a good credit history, making it easier to obtain other forms of financing.
  • For Suppliers:
    • Customer Loyalty: Offering trade credit can strengthen relationships with customers, leading to repeat business and long-term partnerships.
    • Competitive Advantage: Providing trade credit can make a supplier more attractive to potential customers compared to competitors who require immediate payment.

Risks and management of trade credit

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While trade credit provides significant benefits, it also comes with risks that need to be managed effectively:

  • Credit Risk: The risk that the buyer may default on the payment. Suppliers need to assess the creditworthiness of their customers and set appropriate credit limits.
  • Cash Flow Impact: Extending credit can impact the supplier’s cash flow. Effective management involves balancing the need to offer credit with maintaining sufficient cash reserves.

Effective management practices include:

  • Credit Assessment: Evaluating the financial stability and credit history of customers before extending trade credit.
  • Clear Terms: Establishing clear credit terms and conditions, including payment deadlines, discounts for early payment, and penalties for late payment.
  • Monitoring and Follow-Up: Regularly monitoring outstanding invoices and following up with customers to ensure timely payments.

Trade credit is a valuable financial tool that supports business growth and operational efficiency. By managing trade credit effectively, businesses can maintain healthy cash flow, build strong supplier relationships, and enhance their overall financial stability.



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Arti
AI Financial Assistant
Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.