What is a 'Trade Credit'
A trade credit is an agreement where a customer can purchase goods on account (without paying cash), paying the supplier at a later date. Usually when the goods are delivered, a trade credit is given for a specific number of days – 30, 60 or 90. Jewelry businesses sometimes extend credit to 180 days or longer. Trade credit is essentially a credit a company gives to another for the purchase of goods and services.
BREAKING DOWN 'Trade Credit'
The amount of days for which a credit is given is determined by the company allowing the credit, and is agreed upon by both the company allowing the credit and the company receiving it. With the extension of the payment date, the company receiving the credit could sell the goods and use the net proceeds to pay back the debt. This type of credit is sometimes given to encourage sales. At times, a supplier may give a discount, if the customer pays within a certain period of time. For example, a 2% discount if payment is received within 10 days of issuing a 30-day credit.
Trade credit applies to business-to-business trade, and has been an essential way for businesses to finance short-term growth. Vendors or suppliers do not typically extend trade credit to businesses that have yet to establish good credit, or have not proven that they are able to make payments on time. However, trade credit is a useful option for businesses to receive supplies crucial to growth without paying immediately. This way they can sell their product before payment is due, or use the freed up cash flow for other business purposes.
Another way of thinking about trade credit is as a form of short-term debt, and yet it does not require any outright interest, is often in the form of an informal contract, and is not issued by any bank or financial institution. Still, if a supplier or company is not paid within the trade credit agreed terms, penalties in the form of fees and interest can be incurred. It is worthwhile to note that generally the supplier has a vested interest in the survival of the company to which it has extended the trade credit. This ongoing business relationship is different from that of a typical bank and loan borrower in that the supplier can choose to be more flexible with repayment terms; and in fact, often chooses to do so.
‘Trade Credit’ Trends
Trade credit is most rewarding for businesses that do not have a lot of financing options. After the 2008 financial crisis, traditional financing options for small businesses, such as debt and equity financing, became increasingly limited. Evidence of this is seen in the relatively recent rise of alternative means of financing, such as crowdfunding and peer-to-peer lending.
From an international standpoint, studies have found that in countries outside of the United States, trade credit accounts for approximately 20% of all investment financed externally. Bank credit was the only form of financing more significant than trade credit, showing that in most of the surveyed countries, trade credit was the second most important financing option.
Similarly, research conducted in the U.S., such as that of the Survey of Small Business Finances by the Federal Reserve Bank, demonstrate the importance of trade credit. Trade credit is used by approximately 60% of small businesses in the U.S., rendering it the second most popular financing option after that of banks and other financial institutions.
Related Terms & Concepts
Trade credit has a significant impact on the financing of businesses and therefore is linked to other financing terms and concepts. Other important terms that affect business financing and financial futures are credit rating, trade line and buyer’s credit. A credit rating is an overall assessment of the credit worthiness of a borrower, whether a business or individual, based on financial history that includes debt repayment timeliness and other factors. Without a good credit rating trade credit may not be offered to a business.
A trade line, or tradeline, is the credit account record provided to a credit reporting agency, such as Standard & Poor’s, Moody’s or Fitch. Buyer’s credit is related to international trade and is essentially a loan given to importers specifically to finance the purchase of capital goods and services. Buyer’s credit involves different agencies across border lines and thus typically has a minimum loan amount of several million dollars.