Trade credit is a form of short-term financing that allows customers to purchase goods or services from a supplier and pay for them at a later date. It is also known as vendor credit or net terms and is commonly used by business-to-business (B2B) companies. Trade credit can help manage cash flow and build business credit.
How does trade credit work?
Trade credit differs from traditional small-business loans. Instead of a formal agreement between a lender and borrower, trade credit is an informal credit arrangement between a customer and supplier. In this agreement, the supplier provides goods or services, and the customer agrees to pay for them within a specified time frame.
Typically, trade credit terms are offered for 7, 30, 60, 90, or 120 days. These terms are often referred to as “net + number of days.” For example, a net 30 agreement means the customer has 30 days to pay for the purchased goods. Some suppliers may offer discounts for early payment, such as a 3% discount for payment within seven days of the 30-day term.
While trade credit is considered interest-free, suppliers may charge fees for late payments. Responsible use of trade credit, such as making timely payments, can help build business credit. Suppliers may report payment history to business credit bureaus, or customers can list them as trade references to establish credit.
Trade Credit Example:
Suppose a customer connects with a supplier who sells T-shirts for $2.50 each and decides to purchase 1,000 T-shirts. The supplier offers trade credit with a sales price agreement and payment terms of 2/10, net 30. The supplier sends an invoice detailing the price, terms, and late fee policy. If the customer pays within 10 days, they receive a 2% discount, paying $2.45 per shirt. If payment is made on day 30, the total cost is $2,500. Late payments incur additional fees.
How to Get Trade Credit:
To obtain trade credit, customers can inquire with suppliers about available options. Suppliers evaluate the customer’s credit history, business finances, payment history, and relationship with other suppliers. Payment terms are determined based on these factors, industry, purchase size, and product perishability. Suppliers may require customers to sign a promissory note to protect against nonpayment.
Pros and Cons of Trade Credit:
For Customers:
Pros:
– Easier to qualify for than traditional business loans
– Affordable short-term financing
– Discounts for early payments
– Establish relationships with suppliers
– Build business credit
Cons:
– Expensive late fees for delayed payments
– Negative impact on business credit and supplier relationships for late or missed payments
For Suppliers:
Pros:
– Build strong customer relationships
– Encourage customer loyalty
– Increase sales volume
Cons:
– Delays revenue from sales
– Accounts receivable management challenges
– Risk of bad debt if customers do not pay
Alternatives to Trade Credit:
For larger investments: Long-term business loans
For equipment purchases: Equipment financing
For working capital needs: Business line of credit
Frequently Asked Questions:
– How much does trade credit cost?
– What are the most common terms for using trade credit?
– Who offers and uses trade credit?
In summary, trade credit is a valuable financing option for B2B transactions, offering flexibility and benefits for both customers and suppliers. By understanding the terms and responsibilities involved, businesses can effectively utilize trade credit to manage cash flow and build creditworthiness.