Trade credit can be thought of as a type of 0% financing, increasing a company’s assets while deferring payment for a specified value of goods or services to some time in the future and requiring no interest to be paid in relation to the repayment period.
Key Takeaways
- Trade credit is a type of commercial financing in which a customer is allowed to purchase goods or services and pay the supplier at a later scheduled date.
- Trade credit can be a good way for businesses to free up cash flow and finance short-term growth.
- Trade credit can create complexity for financial accounting depending on the accounting method used.
- Trade credit financing is usually encouraged globally by regulators and can create opportunities for new financial technology solutions.
- Suppliers are usually at a disadvantage with a trade credit as they have sold goods but not received payment.
Understanding Trade Credit
Trade credit is an advantage for a buyer. In some cases, certain buyers may be able to negotiate longer trade credit repayment terms, which provides an even greater advantage. Often, sellers will have specific criteria for qualifying for trade credit.
A B2B trade credit can help a business to obtain, manufacture, and sell goods before ever having to pay for them. This allows businesses to receive a revenue stream that can retroactively cover costs of goods sold. Walmart is one of the biggest utilizers of trade credit, seeking to pay retroactively for inventory sold in their stores. International business deals also involve trade credit terms. In general, if trade credit is offered to a buyer it typically always provides an advantage for a company’s cash flow.
The number 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. Trade credit can also be an essential way for businesses to finance short-term growth. Because trade credit is a form of credit with no interest, it can often be used to encourage sales.
Since trade credit puts suppliers at somewhat of a disadvantage, many suppliers use discounts when trade credits are involved to encourage early payments. A supplier may give a discount if a customer pays within a certain number of days before the due date. For example, a 2% discount if payment is received within 10 days of issuing a 30-day credit. This discount would be referred to as 2%/10 net 30 or simply just 2/10 net 30.
Trade Credit Accounting
Trade credits are accounted for by both sellers and buyers. Accounting with trade credits can differ based on whether a company uses cash accounting or accrual accounting. Accrual accounting is required for all public companies. With accrual accounting, a company must recognize revenues and expenses at the time they are transacted.
Trade credit invoicing can make accrual accounting more complex. If a public company offers trade credits it must book the revenue and expenses associated with the sale at the time of the transaction. When trade credit invoicing is involved, companies do not immediately receive cash assets to cover expenses. Therefore, companies must account for the assets as accounts receivable on their balance sheet.
With trade credit, there is the possibility of default. Companies offering trade credits also usually offer discounts, which means they can receive less than the accounts receivable balance. Both defaults and discounts can require the need for accounts receivable write-offs from defaults or write-downs from discounts. These are considered liabilities a company must expense.
Alternatively, trade credit is a useful option for businesses on the buying side. A company can obtain assets but would not need to credit cash or recognize any expenses immediately. In this way, trade credit can act like a 0% loan on the balance sheet.
The company’s assets increase but cash does not need to be paid until some time in the future and no interest is charged during the repayment period. A company only needs to recognize the expense when cash is paid using the cash method or when revenue is received using the accrual method. Overall, these activities greatly free up cash flow for the buyer.
Trade Credit Trends
Trade credit is most rewarding for businesses that do not have a lot of financing options. In financial technology, new types of point of sale financing options are being provided for businesses to utilize in place of trade credits. Many of these fintech firms partner with sellers at the point of sale to provide 0% or low-interest financing on purchases. These partnerships help to alleviate trade credit risks for sellers while also supporting growth for buyers.
Trade credit has also brought about new financing solutions for sellers in the form of accounts receivable financing. Accounts receivable financing, also known as invoice financing or factoring, is a type of financing that provides businesses with capital in relation to their trade credit, accounts receivable balances.
From an international standpoint, trade credit is encouraged. The World Trade Organization reports that 80% to 90% of world trade is in some way reliant on trade finance. Trade finance insurance is also a part of many trade finance discussions globally with many new innovations. LiquidX for example now offers an electronic marketplace focused on trade credit insurance for global participants.
Research conducted by the U.S. Federal Reserve Bank of New York also highlights some important insights. The 2019 Small Business Credit Survey finds that trade credit finance is the third most popular financing tool used by small businesses with 13% of businesses reporting that they utilize it.
