written by | January 4, 2023

Everything about Trade Credit and How it Works

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Table of Content


Trade Credit is a form of credit that is extended to businesses by vendors when they purchase goods or services. It is an agreement between the buyer and seller, where the seller agrees to sell goods or services to the buyer without immediate payment. The buyer, in turn, agrees to pay for the goods or services at a later date. Trade credit is a type of financing that is often used by businesses to finance their operations or to help them manage their cash flow.

Trade credit is an important financial tool for businesses, as it allows them to purchase goods or services without having to pay cash upfront. It also helps businesses manage their cash flow by allowing them to purchase goods or services when they need them, without having to wait for the cash to come in from other sources. However, it is important for businesses to use trade credit responsibly and to be aware of the terms of the loan. Businesses should also keep track of their trade credit accounts to ensure that they are paying back their loans on time and in full.

Did you know? The length of time that the buyer has to pay back the loan taken as trade credit will depend on the vendor’s policies, but typically the buyer only has 30 to 90 days to repay the loan.

What is Trade Credit?

Trade credit is a type of financing that is used by businesses to finance their operations or to help them manage their cash flow. It involves the agreement between the buyer and seller, where the seller agrees to sell goods or services to the buyer without immediate payment. The buyer in turn agrees to pay for the goods or services at a later date. This helps businesses purchase goods or services that they need to operate without having to use their own cash reserves.

When a business purchases goods or services on trade credit, it is essentially taking out a loan from the vendor and agreeing to pay for the goods or services at a later date. The vendor agrees to extend the loan to the business in exchange for a promise of future payment. The terms of the loan will be specified in the contract between the buyer and the vendor. This contract will outline the amount of the loan, the interest rate (if any), the repayment schedule, and any other terms or conditions of the loan. The terms of the loan will vary depending on the vendor and the type of goods or services that are being purchased.

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How Trade Credit Works?

The buyer will typically pay a fee for the loan in the form of a discount. This discount is the difference between the amount of the loan and the amount that the buyer would have paid if they had paid in cash. The amount of the discount will also depend on the terms of the loan and the creditworthiness of the buyer.

Once the loan is paid back, the vendor will typically provide the buyer with an invoice. This invoice will include the amount of the loan, the interest rate (if any), the repayment schedule, and any other terms or conditions of the loan. The buyer will then pay the invoice in full by the due date.

Types of Trade Credit

Trade Credit can be offered in a variety of forms, each with its own advantages and disadvantages. There are multiple types of trade credit operating today which is used as per the requirement. Let us figure out some types of trade credits.

Open Account

The most common form of Trade Credit is the Open Account. This type of credit allows companies to purchase goods and services without having to pay upfront. It allows companies to pay for the items over time with pre-determined terms, such as payment due dates and discounts for early payment. This type of Trade Credit is often used by companies who have established relationships with their suppliers and vendors, as they are more likely to trust each other. The main advantage of the Open Account is that it is a flexible form of financing, allowing companies to purchase items when needed and pay for them over time. 

Cash Discounts

Another type of Trade Credit is the Cash Discount. This type of credit extends discounts to businesses that pay for their purchases within a certain period of time. For instance, a vendor may offer a 3% discount for payments that are made within 10 days of the purchase date. This type of Trade Credit is often used to encourage businesses to pay their bills quickly, as vendors can then use the cash to pay their own suppliers. The main advantage of Cash Discounts is that businesses can save money by taking advantage of the discounts. 

Credit Card

Credit cards are another type of Trade Credit that businesses can use to purchase items. Credit cards allow businesses to borrow money from the card issuer and pay for their purchases over time. Credit cards are often used for convenience, as businesses can purchase items without having to pay for them upfront. Additionally, some credit cards offer rewards and cash-back programs, which can help businesses save money. The main disadvantage of credit cards is that they often have high-interest rates, which can make it difficult to pay them off in a timely manner. 

Line of Credit

A Line of Credit is another type of Trade Credit that businesses can use to purchase items. A Line of Credit allows businesses to borrow money from a lender, such as a bank, and then use the funds to purchase items. Lines of Credit usually have pre-determined terms, such as interest rates, repayment periods and payment schedules. The main advantage of a Line of Credit is that it gives businesses access to funds when they need it, allowing them to purchase items quickly. The main disadvantage of a Line of Credit is that the interest rates are often higher than other forms of Trade Credit.

Factoring

Factoring is a type of Trade Credit that businesses use to obtain financing from their customers. Factoring involves selling a company’s receivables to a third party at a discounted rate in exchange for immediate cash. This type of Trade Credit is often used by businesses that have difficulty obtaining financing from traditional lenders, as it allows them to convert their receivables into cash quickly. The main advantage of Factoring is that it gives businesses access to funds quickly, allowing them to purchase items without having to wait for customers to pay their bills. The main disadvantage of Factoring is that the factoring company will charge a fee for their services, which can reduce the amount of cash the business receives.

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Advantages of Trade Credit

Trade credit benefits many types of business that can be big or small. This helps to get credit on an urgent basis and repay them later. Let us read some more advantages of Trade Credit.

Easier access to working capital

One of the most significant advantages of trade credit is that it allows businesses to access working capital in a relatively easy way. Trade credit helps to free up capital that can be used to purchase additional inventory or invest in other areas of the business. 

Maintain a good credit score

Trade credit helps to maintain a good credit score, which is essential for obtaining other forms of credit. By using trade credit to pay for goods and services, businesses can demonstrate that they are reliable and responsible when it comes to managing their finances. This helps to build trust with creditors and makes it easier for them to provide additional funds when needed. 

Lower costs

Trade credit is often more cost-effective than other forms of financing. This is because there are no interest rates or other fees associated with trade credit. This makes it an attractive option for businesses looking to save money.

Flexibility

Trade credit is also very flexible. Businesses can use it to purchase goods and services at any time and can pay back the balance when they choose. This allows businesses to maintain a strong cash flow and avoid the risk of being unable to pay back a loan.

Build relationship

Trade credit is also a great way to build relationships with suppliers and other vendors. By using trade credit, businesses can demonstrate that they are reliable and dependable when it comes to making payments. This can result in better deals in the future and further develop the relationship between the two parties. 

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Disadvantages of Trade Credit

Along with advantages, trade credit also has some of the disadvantages that adversely affects the people receiving the credit or the ones providing the credit. Let us read some of the points below.

Potential for late payments

The biggest downside of trade credit is that it can lead to late payments. If a business fails to make payments on time, it can damage the relationship between the two parties and result in penalties or even termination of the agreement. This can have a negative impact on the business’s finances.

Maximum credit limit

Another disadvantage of trade credit is that it typically has a maximum credit limit. This means that businesses may not be able to obtain all the goods and services they need if the credit limit is reached.

Repayment terms

Trade credit also typically has strict repayment terms. This means that businesses must make payments on time or risk penalties or termination of the agreement. This can be difficult for businesses with limited resources.

Limited liquidity

Trade credit is not as liquid as other forms of financing. This means that businesses cannot access the funds as quickly as they can with loans or other forms of credit.

Security

Trade credit also typically requires some form of security, such as a lien on assets or a personal guarantee from the business owner. This can be difficult for businesses with limited assets or collateral.

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Conclusion

In conclusion, trade credit is a form of credit that is extended to businesses by vendors when they purchase goods or services. It allows businesses to purchase goods or services without having to use their own cash reserves, and it helps them to manage their cash flow. However, businesses should only use trade credit when it is absolutely necessary and they should be sure to make the payments on time, as failure to do so could have a negative impact on the business.

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FAQs

Q: How do I protect my business when offering Trade Credit?

Ans:

To protect your business when offering trade credit, it is important to thoroughly assess the customer’s creditworthiness, payment history, and ability to pay. It is also important to create a solid agreement with clear terms and to establish a payment plan. Additionally, it is important to understand the potential risks associated with trade credit, such as non-payment and increased competition.

Q: What is the difference between Trade Credit and Invoice Financing?

Ans:

Trade credit is an agreement between a customer and supplier that allows the customer to purchase goods and services and defer payment until a later date. Invoice financing is a type of financing in which the lender provides a loan to the borrower against unpaid invoices. Trade credit is typically used for short-term purchases, whereas invoice financing is typically used for long-term purchases.

Q: What factors should be considered when offering Trade Credit?

Ans:

When offering trade credit, it is important to consider the customer’s creditworthiness, the customer’s payment history, the customer’s ability to pay, the terms of the agreement, and the supplier’s risk tolerance. It is also important to consider the potential risks associated with trade credit, such as non-payment and increased competition.

Q: What is the difference between Trade Credit and Accounts Receivable?

Ans:

Trade credit is an agreement between a customer and supplier that allows the customer to purchase goods and services and defer payment until a later date. Accounts receivable is the amount of money owed to a company by its customers who have purchased goods and services on credit. Trade credit is typically used for short-term purchases, whereas accounts receivable is typically used for long-term purchases.

Q: What is the difference between Trade Credit and Bank Credit?

Ans:

The primary difference between trade credit and bank credit is that trade credit is extended by a supplier directly to their customers, whereas bank credit is extended by a bank or other financial institution. Trade credit is typically unsecured and is used for short-term purchases, whereas bank credit is typically secured and used for long-term loans.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.