Trade credit is a type of commercial financing in which a customer is allowed to purchase goods or services without paying cash up front, and instead pay at a later date. It is a loan extended by one trader to another when the goods and services are bought on credit. Trade credit is commonly used by business organizations as a source of short-term financing, and it is granted to those customers who have a reasonable amount of financial standing and goodwill. Usually, businesses that operate with trade credits will give buyers 30, 60, or 90 days to pay, with the transaction recorded through an invoice. 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 features of trade credit include:
- Collaboration of businesses: Trade credit involves the collaboration of businesses to make efficient use of capital to accomplish various business objectives.
- Various forms: There are many forms of trade credit in common use, and various industries use various specialized forms.
- Largest use of capital: Trade credit is the largest use of capital for a majority of business-to-business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses.
- Risk management tool: Trade credit insurance is a risk management tool that protects businesses from bad debts by insuring accounts receivable and protecting businesses from unpaid invoices caused by customer bankruptcy, default, political risks, or other reasons agreed with the insurer.
Trade credit can be a good way for businesses to free up cash flow and finance short-term growth. However, it can create complexity for financial accounting depending on the accounting method used. Customers don’t automatically receive trade credit terms from their suppliers, and the credit management team uses certain methods of analysis or software reports and predictive analytics tools to decide.
