The simple definition of trade credit is when a supplier of goods or services provides credit to a customer allowing the customer to pay for the goods or services at a later date. Trade credit is more complex than its definition implies. There are multiple functions of trade credit. A business must also consider both the positive and negative costs and the significant impact of trade credit on their business financially. There is also more than one type of trade credit. Here is a brief introduction to what trade credit is, and what it means to business.
Trade credit is a term used for the relationship between a business which provides goods or services using payment terms and the customer who uses those terms to purchase from the provider. When a firm provides this type of credit, they are agreeing to receive payment at a later date. Trade credit is among the most used sources of capital for American business outside of bank loans.
Trade credit can have multiple functions depending on the situation. This type of credit most often has the function of providing a portion of the capital investment for small or start-up businesses. In developing countries the use of trade credit as collateral for other types of financing is a common function as this means there is a ready source of income if the business is the supplier, or a ready source of material if the business is the customer. Another function of trade credit for business is to finance growth. Used in this manner, a business can put off expenses while increasing revenues.
The significance of using trade credit is not only in terms of working capital but also in the definition and premium of those terms. Trade credit, if used properly, can provide not only a useful means to increase capital but also as a way to build a commercial credit history because on-time payments show a record of financial stability and success.
On the other side, both the lack of trade credit as well as the ineffective use of credit can lead to higher operating costs and damage to future commercial credit. Trade credit is similar to personal credit in this regard where constant and consistent payment improves the borrowers ability to gain more credit, while slow or non-payment can destroy any future financial gains.
Trade credit, when not handled properly, can also effect insurance rates and be a sign of either future distress or inability of management to handle the business.
While trade credit can be an important portion of working capital, it can also be an expensive portion. Depending on the terms of the agreement, the interest rate or due date can be altered or have penalties involved if payments are delayed. There are also discounts for early payment to a line of credit.
An example of these terms would be stated as 2% in 10 days, net 30 days.
The example above has a 2% discount to the amount owed if paid within 10 days with the full amount being due within 30 days of a business receiving the invoice. Using this example a business would show a 36% annual interest savings if the discount was consistently used.
If you received a bill for $1,000 and paid within 10 days you would be allowed a discount of $20. Over 12 months this gives a discount of $240 or nearly a quarter of one months payment.
Trade credit can also have a negative cost as well. Most agreements provide for late-payment and delinquency penalties if a business falls behind in paying its bills. While this normally amounts to only 2% over 30 days, in the time frame of one year this would amount to an interest penalty of up to 24%, raising the amount owed by a quarter of the original total.
If your business received a bill for $1,000 and paid late, you would incur a penalty of $20. Over the course of one year that would amount to $240 added to the total paid during the year.
As a trade off to paying early to receive the discount rate, many businesses consider the ability to use that money for another 20 days before the full amount is due to increase revenue thereby lowering the cost of trade credit.
Many industries use a specialized form of trade credit for their field. Two of the most widely used trade credit accounts are Net 30 and Net 10. These accounts have a smaller window of time for payment but also offer easier terms and flexibility to manage payments over time.