Trade Credit

Understanding Trade Credit

Trade credit is a business-to-business arrangement that lets a buyer receive goods or services and defer payment to a later date—typically 7, 30, 60, 90, or 120 days—often without interest. It functions as short-term, interest-free financing for the buyer and creates an accounts receivable for the seller.

How Trade Credit Works

• A seller ships goods and issues an invoice with payment terms (e.g., 2/10 net 30 means a 2% discount if paid within 10 days; otherwise full payment is due in 30 days).
• Buyers use the goods, generate sales, and pay the supplier later, improving cash flow and freeing working capital.
• Sellers increase sales and build customer relationships but take on collection and default risk.
• Trade credit can be negotiated; larger or established buyers may secure longer terms.

Accounting Considerations

• Under accrual accounting (required for public companies), revenues and related receivables or payables are recorded at the time of the transaction, even if cash isn’t received.
• Sellers record accounts receivable and must estimate allowances for discounts, returns, or bad debts; defaults or discounts may require write-offs or write-downs.
• Buyers record accounts payable; under cash accounting, expenses are recorded when paid, which can make trade credit appear like a 0% loan on the balance sheet until payment is made.

Common Types and Terms

• Open account: Informal invoicing arrangement where payment is expected by the due date.
• Promissory note: Formal written agreement specifying payment terms and a signed promise to pay.
• Bills payable: Financial instruments accepted by the buyer promising payment on a future date.
• Typical payment windows: 7, 30, 60, 90, or 120 days; early-payment discounts are common.

Risks and Costs

• For buyers: If payments are late, penalties, interest charges, and damaged credit histories can make trade credit costly.
• For sellers: Delayed revenue strains cash flow; nonpayment leads to bad-debt write-offs and increased collection costs.
• While trade credit is interest-free when terms are met, effective cost can be high if discounts are forgone or late fees apply.

Trends and Innovations

• Fintech solutions are increasingly offering point-of-sale financing and partnerships that provide 0% or low-interest alternatives, reducing seller risk.
• Accounts receivable financing (invoice financing/factoring) helps sellers convert receivables into immediate cash.
• Trade finance insurance and electronic marketplaces for trade-credit insurance are growing to support cross-border transactions.
• Trade credit remains a widely used tool: a meaningful share of small businesses rely on it as a short-term financing source.

Related Concepts

• Credit rating: A buyer’s creditworthiness affects availability and terms of trade credit.
• Trade line: A record of a business’s credit account used by business credit reporting agencies.
• Buyer’s credit: A cross-border loan used to finance purchases of capital goods, typically involving larger sums and different institutions.

Advantages and Disadvantages

Advantages for buyers:
– Immediate access to inventory or services without upfront cash.
– Improved short-term cash flow and working capital management.
– Often cheaper than alternative financing when terms are met.

Advantages for sellers:
– Increased sales and stronger customer relationships.
– Competitive advantage by offering flexible payment terms.

Disadvantages for buyers:
– Late payments can lead to high costs and damaged credit.
– Reliance on trade credit can mask underlying cash-flow problems.

Disadvantages for sellers:
– Risk of nonpayment and bad debts.
– Delayed cash inflows that can strain operations.

Key Takeaways

• Trade credit is a common, short-term B2B financing tool that helps buyers manage cash flow and helps sellers boost sales—but it transfers default and collection risk to sellers.
• Proper accounting, clear payment terms, and risk-management strategies (discounts, credit checks, insurance, factoring) are essential to benefit from trade credit while minimizing exposure.
• Emerging fintech and invoice-financing solutions can reduce seller risk and expand options for buyers.