Trade Credit
Trade credit is a financial arrangement in the business sector that allows one business to purchase goods or services from another with a delayed payment option. This system facilitates smooth transactions between businesses, enabling them to manage cash flow more effectively. For example, a small business may need inventory to make sales but lack immediate funds to cover upfront costs. Trade credit allows them to receive products now and pay for them later, often within a specified period such as 30 or 60 days, sometimes with discounts for early payment.
The terms of trade credit agreements are often communicated using shorthand notations, like "2/10/30," which indicates a 2% discount if payment is made within 10 days, with full payment due in 30 days. Establishing trade credit often requires a history of reliable transactions, with new buyers initially paying cash or providing credit references until trust is built. This system not only aids individual businesses but also enhances the overall efficiency of the market by streamlining the flow of goods and services.
On this Page
Trade Credit
Trade credit is a concept primarily relevant in the business world, particularly in the context of transactions between businesses. Such transactions happen constantly even though many consumers are not directly aware of them; it is not unusual for dozens of business-to-business transactions to be necessary to support a single sale by a business to a customer. The business interacting with the customer must first purchase the products it intends to sell from manufacturers or wholesalers. It may then need to purchase shipping services from another company in order to receive the items for its inventory, purchase insurance on the as yet unsold inventory, and so on. If each of these "background" transactions had to be paid in full up front, the exchange of goods and services would be drastically slowed at best. Trade credit enables merchants to extend credit lines to each other in order to speed up the flow of commerce.
Brief History
Merchants are often faced with a "chicken and egg" problem, especially when they are first starting out, do not have much operating capital in reserve, and need to start earning revenue quickly in order to remain in business. It is easy to imagine a small business with no funds remaining after renting its offices and hiring staff. The business needs to purchase inventory, which it can then sell to customers at a profit. If the wholesaler from whom the business needs to purchase the inventory demands immediate payment for the goods up front, the business owner will be stuck—she doesn’t have the money to buy the goods from the wholesaler, but she needs the goods to sell to the customer. It is unlikely that she can borrow the money from a bank, because the bank would have no guarantee that she will actually be able to sell the goods, generate a profit, and pay back the loan. At the very least, she will need to spend time pulling together the finances needed in order to purchase the inventory. This is, in a sense, time that is wasted because it could be better spent selling products to customers.
Trade credit solves this problem, because it is a system in which the wholesaler can sell the goods needed for inventory under terms that allow the business owner to have some time (thirty or sixty days are typical timeframes) to send payment to the wholesaler. For example, the wholesaler might offer terms that provide for repayment within sixty days at a rate of 4 percent interest, or a rate of 2 percent interest if the payment is received within thirty days. This gives the business owner buying the goods an incentive to try harder to sell them quickly, in order to pay off the amount due at a lower interest rate, saving money for the business owner. Many trade credit arrangements use a type of shorthand to express the terms of the payment arrangement, such as "2/10/30." Each number in this expression has its own significance. The 30 refers to the fact that the entire amount owed must be repaid within thirty days of the purchase. The 10 indicates that if payment in full is received within ten days, then a discount will be provided. The 2 is the amount of that discount, expressed as a percentage of the purchase price. So, if a sale between merchants is under terms of 2/10/30, then the buyer has thirty days to pay the full price or the buyer may instead deduct 2 percent from the purchase price and pay the remainder within ten days.
Overview
Some merchants follow internal policies which require that, when they begin working with a new buyer, trade credit will not be offered until the buyer has established that they are reliable enough to be trusted to receive goods and pay for them later. This means that, at the outset, a buyer must pay cash upon delivery until a satisfactory payment history has been established between the buyer and the seller. As an alternative, some merchants may request credit references from a new buyer, which take the form of assurances from others with whom the buyer has done business, that the buyer is reliable and pays his or her debts on time.
In practice, once trade credit has been established between the buyer and seller, both entities process orders using a number of standard business forms. When the buyer wishes to place an order, the buyer prepares a document called a purchase order. The purchase order has a unique number which both the buyer and seller can use to track the order with. The purchase order is transmitted to the seller by the buyer, and the buyer then enters the purchase order into its accounting and inventory system and ships out the goods. The buyer also sends an invoice (which has its own unique number), which is a summary of what the buyer purchased and the total cost of the order, including shipping and taxes.
An important detail is that not all of the goods listed on the purchase order may appear on the invoice. This can happen when a buyer orders items that are not currently in stock or that have been discontinued. The invoice will only list the items that were actually sent to the buyer. The invoice will also list the date on which the payment is due. By using these forms and this process, both buyer and seller can keep track of what was ordered and when, as well as what was shipped and when. If some items on a purchase order are not included in the seller’s initial shipment because they are backordered, then when they are ready they will ship out along with another invoice. Trade credit can be an intricate process to keep track of, but it offers huge advantages for buyers and sellers alike.
Bibliography
Amato, Massimo, and Luca Fantacci. The End of Finance. Polity, 2012.
Bornstein, Gideon. “How Trade Credit Is a Double-Edged Sword.” Knowledge at Wharton, University of Pennsylvania, 15 Aug. 2023, knowledge.wharton.upenn.edu/article/how-trade-credit-is-a-double-edged-sword/. Accessed 6 Dec. 2024.
Baker, H. K., and Greg Filbeck. Portfolio Theory and Management. Oxford UP, 2013.
Baumohl, Bernard. The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities. FT P, 2013.
Conard, Edward. Unintended Consequences: Why Everything You've Been Told About the Economy Is Wrong. Penguin, 2012.
Cumming, Douglas. The Oxford Handbook of Entrepreneurial Finance. Oxford UP, 2012.
Herdegen, Matthias. Principles of International Economic Law. Oxford UP, 2013.
Kagan, Julia. “Trade Credit: Definition, Accounting, and Pros & Cons.” Investopedia, 17 July 2022, www.investopedia.com/terms/t/trade-credit.asp. Accessed 6 Dec. 2024.
Lessambo, Felix I. The International Banking System: Capital Adequacy, Core Businesses and Risk Management. Palgrave, 2013.
Nosal, Ed, and Guillaume Rocheteau. Money, Payments, and Liquidity. MIT P, 2012.
“Trade Credit.” Corporate Financial Institute, corporatefinanceinstitute.com/resources/accounting/what-is-trade-credit/. Accessed 6 Dec. 2024.