Trade credit explained (definition, pros, cons, examples)

Pia Mikhael is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.

Trade credit is a valuable tool for managing business cash flow, letting you buy goods or services now and pay for them later. It's especially important in industries where cash flow can be unpredictable. 

Using trade credit helps you manage your business finances and credit limits effectively without immediate cash outflow—whether it's optimizing your operating cash flow, negotiating better terms with suppliers, or simply understanding your financial obligations better.

However, like any financial tool, trade credit has benefits and challenges. From improving liquidity to potential risks of overextension, being aware of these advantages and disadvantages is key to making informed decisions. 

Key takeaways

• Trade credit is a common strategy or form of financing used by organizations to increase sales volume, build long-term and strong relationships with customers, and develop customer loyalty.
• Trade credit arrangements or net payment terms are common in practically every field where business-to-business deals occur.
• Trade credit payment terms specify when the customer is expected to make the postponed payment.
• Using trade credit, a business can arrange raw materials and begin the production process.

What is trade credit?

Trade credit is a B2B arrangement that allows you to buy goods or services now and pay later. You receive products from suppliers without immediate payment, and agree to settle the bill within a set timeframe of 30 to 90 days.

By using trade credit, you can improve cash flow and stock inventory without upfront costs and grow your business. Suppliers use trade credit to attract customers, encourage more significant purchases, and build lasting relationships.

Moreover, trade credit significantly impacts cash flow by delaying payments and aligning expenses with revenue, freeing up capital for other business needs.

What type of credit is trade credit?

Trade credit is a unique form of short-term, interest-free financing suppliers or lenders provide. 

In your accounting, you record it as "accounts payable" on the balance sheet. Unlike traditional loans, trade credit financing remains unsecured, meaning suppliers do not require collateral.

Trade credit functions as a 0% financing option, allowing the borrower to defer payment without incurring interest charges. This makes it an attractive and cost-effective way to manage your business's short-term financial needs or working capital. 

What are the different types of trade credit?

Trade credit comes in various forms, each tailored to different business needs, and understanding these types can help you choose the most suitable option for your company's financial strategy. 

Here are the main types of trade credit:

• Open account: You receive goods or services along with an invoice, agreeing to pay within a specified period. The due date is within the next 30 to 90 days.
• Installment credit: You repay the credit in equal installments over time, similar to a standard loan. 
• Revolving credit lines: This allows you to repeatedly access credit up to a set limit. As you make payments, your available credit replenishes, offering ongoing flexibility.
• Consignment credit: You sell goods provided by a supplier without paying for them upfront. You only pay the supplier after selling the goods, thereby sharing the profit.
• Trade acceptance: This involves a formal agreement between you and the supplier before the sale. You sign the agreement before receiving the goods or services.
• Promissory note: You issue a written promise to pay a specific amount to the supplier by a certain date. You make this formal agreement before the transaction occurs.

Is trade credit expensive?

Trade credit is generally an affordable financing option for buyers. When you pay on time, it's essentially free. Many suppliers even offer discounts for early payment, making it cost-effective. 

However, if you miss payment deadlines, you may incur interest charges, which can increase costs.

What is a trade credit period?

A trade credit period is the timeframe you have to pay for goods or services after receiving them. Standard periods include 30, 60, or 90 days but vary by industry. 

Also, some factors influencing the credit period include:

• The risk of non-payment
• The size of the account
• How quickly the goods lose value

What are some trade credit instruments?

Trade credit instruments are documents used to formalize the credit agreement:

• Open account: The most common form, using only an invoice.
• Promissory note: A written promise to pay by a specific date.
• Commercial draft: A document requesting payment, often used before shipping goods.
• Banker's acceptance: A guarantee from a bank to pay the seller.

Trade finance vs. trade credit

Although they are often used interchangeably, these terms have distinct meanings. 

Trade finance is a broad term covering various financing options in business transactions, including trade credit. 

Trade credit refers to the practice of allowing a buyer to receive goods or services and pay later.

Trade credit advantages and disadvantages

There are various reasons why a business might think about providing or obtaining trade credit and paying for the cost of trade. 

If you're one of those businesses, here are some key benefits of trade credit as well as disadvantages as a source of finance:

Trade credit for buyers

Trade credit for sellers

Trade credit accounting

What is trade credit accounting?

Trade credit accounting is a financial practice of recording and managing transactions where a buyer purchases goods or services from a supplier without making an immediate cash payment. 

It affects both buyers and sellers differently, depending on whether they use cash or accrual accounting methods. 

Accrual accounting is mandatory for public companies, requiring them to record revenues and expenses when they occur, not when cash changes hands.

How do you record trade credit?

Your recording method depends on your accounting system:

• With cash accounting, you record transactions when you receive or pay money.
• In accrual accounting, you record transactions when they occur, even if no money has changed hands yet.

What is the net method for trade counting accounting with discounts?

The net method involves recording the invoice amount minus any discount as a single figure. 

Let’s suppose that you buy goods worth $5000 with a $500 discount. So, if you pay early and take the discount, you'd record the payment as $4500. Whereas, if you pay late and lose the discount, you'd record $500 and show the lost discount separately.

AP turnover and trade credit

The accounts payable (AP) turnover ratio helps assess how soon a company pays its trade credit debts. It shows how many times a year a company pays off its accounts payable. 

This is why sellers often use this ratio to decide whether to offer trade credit to potential buyers.

Usually, a higher AP turnover ratio generally indicates that a company pays its debts on time, which may make it more likely to receive favorable trade credit terms.

What is trade credit insurance (TCI)?

Trade Credit Insurance (TCI), also known as accounts receivable insurance, protects your business when you sell goods or services on credit. It covers you if your customers can't pay due to bankruptcy or other financial issues.

How does trade credit insurance work?

When you get TCI, the insurer evaluates your business and your customers. They look at factors like your sales volume,  customers' financial health, and industry. Based on this, they set coverage limits for each customer. If a customer doesn't pay, the insurance covers your loss up to that limit.

Advantages

The advantages of TCI include:

• You can sell more with better confidence to existing and new customers.
• It helps you expand into new markets, especially internationally.
• Banks may offer you better financing terms with TCI in place.
• You gain valuable insights about market trends and customer creditworthiness.
• It frees up capital you'd otherwise set aside for potential losses.
• The insurance pays out if a customer can't pay due to insolvency.

Disadvantages

Aside from these benefits, some insuring trade credit disadvantages include:

• The insurer might not cover high-risk customers.
• There's a cost involved, generally less than 1% of your insured sales.

Note: Please be sure to read your policy terms carefully to understand relevant risks.

What are credit put options for trade credit?

Credit put options are another way for larger companies to manage trade credit risk. They let you sell unpaid invoices from bankrupt customers back to a bank, giving you full coverage without a deductible. 

These options are available for more significant amounts and longer terms than typical TCI.

Credit analysis

When you offer credit to customers, you need to assess if they'll pay you back. 

Here's how you can do this:

• Ask for their financial statements to check their financial health.
• Get credit reports that show their payment history with other companies.
• Ask banks for information about the customer's creditworthiness.
• Look at the customer's past payment record with your company.
• Consider the "5 C's of credit": Character, Capacity, Capital, Collateral, and Conditions.

Trade credit examples

Here’s an example of how trade credit operates across various industries, providing specific examples of how buyers and suppliers interact. 

In this table,

• The "Payment Terms" column explains the conditions for making the payment.
• The "Credit Period" specifies the exact time frame allowed for payment

Trade credit cost example: early payment

Suppliers often offer discounts to encourage early payment. For example:

You buy goods worth $1,000. The supplier offers "2/10 Net 30" terms. This means:

• You get a 2% discount if you pay within 10 days.
• Otherwise, you must pay the total amount within 30 days.

If you pay early, you save: $1,000 x 2% = $20

Trade credit cost example: late payment penalty

If you pay late, you might face penalties. For instance:

• You owe $1,000, and the supplier charges a 12% annual late fee.
• If you're 30 days late, you'll owe an extra $1,000 x (12% / 12 months) = $10

FAQs about trade credit

What are trade credit services?

Trade credit services allow businesses to purchase goods or services from suppliers without immediate payment. These services involve agreements where buyers can delay payment for a specified period, often 30, 60, or 90 days after receiving the goods or services.

Is a trade credit a loan?

Trade credit is not a loan, but it functions in a manner similar to allowing businesses to defer payment. It's a form of short-term financing provided by suppliers to their customers, without involving a financial institution or formal loan agreement.

Is trade credit short-term?

Yes, trade credit is generally considered short-term financing. It involves payment terms ranging from a few days to a few months, with 30 to 90 days being the most common repayment period.

Is trade credit a good source of short-term financing?

Trade credit can be an excellent source of short-term financing for many businesses. It allows companies to manage cash flow more effectively and get necessary goods or services without immediate payment, but it's important to consider the terms and your ability to repay on time.

What is the trade credit formula?

The formula for trade credit calculates the amount you need to pay based on the borrowed amount and any applicable discounts. It's expressed as:

Amount to be pay = Borrowed Amount x (1-discount)

Conclusion: Streamline your cash management

Trade credit is an interest-free loan that allows a buyer to purchase things with payment due later at no extra cost. This improves cash flows while avoiding traditional lending charges.

To further streamline your cash flow management, you can take a look at Rho’s accounting management features that automate invoice management and payment. 

This means you no longer have to spend time approving payments; Rho intelligently evaluates your spending based on the rules you set, flagging transactions that need your attention.

Schedule a demo with a Rho expert today to know more!

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Rho is a fintech company, not a bank. Checking and card services provided by Webster Bank, N.A., member FDIC; savings account services provided by American Deposit Management Co. and its partner banks.

Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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