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A Guide to Trade Credit in Business

What Is Trade Credit & How Does It Work?
Lauren Ward
Lauren WardUpdated July 14, 2022
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What is trade credit and how can it help a small business? A trade credit is a business to business (B2B) transaction where one business is able to procure goods or services from the other without immediately paying for them. It’s called a trade credit because when a seller allows a buyer to pay for goods or services at a later date, they are extending credit to the buyer. Trade credit can be a great tool for a small business that can free up cash flow and grow a company’s assets. However, there are some drawbacks, including a short financing window and potentially high interest if you need to extend that window. Here’s what every small business needs to know about trade credit.

What Is Trade Credit?

If you’ve never quite understood the definition of trade credit, it’s simply a formal name for a common agreement between two companies where one company is able to purchase goods from the other without paying any cash until an agreed upon date. You can think of trade credit the same way as 0% financing but with shorter terms. 

How Does Trade Credit Work

Sellers that grant their customers trade credit generally give them anywhere between 30 and 120 days to pay for the goods or services they received on credit. The range, however, can be higher or lower depending on the industry and individual seller. Often, the seller will offer the buyer a discount if they settle their account earlier than the balance due date. If they do offer a discount, the terms of the trade credit sale are usually written in specific format. For example, if the seller offers a 5% discount if the invoice is paid within 20 days, but is willing to give the buyer a maximum of 45 days to pay the invoice, that agreement would be written as:5/20, net 45.If the buyer is unable to pay their invoice within the set time period (which is 45 days in the above example), the vendor will typically charge interest. If that happens, trade credit is no longer an interest-free form of financing.

Who Uses Trade Credit

Business trade credit is very common in the B2B ecosystem. Businesses that use trade credit include:
  • Accountants/bookkeepers
  • Advertising/marketing agencies
  • Construction/landscaping companies
  • Food suppliers
  • Restaurants
  • Manufacturers
  • Wholesalers
  • Retailers
  • Cleaning services

Pros and Cons of Trade Credit

For Buyers

Pros: 
  • Frees up cash Because payment is not due until later, trade credits improve the cash flow of businesses, enabling them to sell goods they acquired without having to pay for those goods until a future date. It can be a good option for companies expanding into a new market or that have seasonal peaks and dips.
  • Possible discount Depending on the trade credit agreement, if the buyer pays the invoice within a certain amount of time, they may receive a discount on the goods or services they purchase.
  • 0% interest The cost of capital can be a burden on some small businesses. If the buyer can settle the invoice within the agreed upon time frame, there is no interest charged on this type of financing. 
Cons:
  • Short payment period The length of the trade credit payment term varies, but they are often less than 120 days, which is shorter than most types of loans for businesses. For a growing small business, this may not be enough time. Companies that need a longer repayment period may want to look into other types of debt instruments.
  • It’s easy to over-commit With discounts and wholesale prices, it can be tempting to buy too much of a particular good. Not only does this create excess inventory, but it also creates a bigger debt obligation. 
  • Possible penalties for late payments Depending on the trade credit agreement, there may be negative consequences for late payments, such as interest or a fine. In addition, the company might report your late payment to the credit bureaus, which could damage your business’s credit score. 
Recommended: 6 Business Cash Management Tips

For Sellers

Pros:
  • Beat out competitors Companies offering trade credit may be able to gain an advantage over industry peers that don’t offer trade credit. Because it can be difficult for some small businesses to get a bank loan, they may seek out suppliers offering trade credit. 
  • Develop a strong relationship with clients Offering trade credit increases customer satisfaction, which can lead to customer loyalty and repeat business.
  • Increase sales Trade credits are still sales even if payment is delayed. Trade credit can also encourage customers to purchase in higher volumes, since there is no cost to the financing. Therefore, a trade credit can provide the opportunity for growth and expansion.
Cons:
  • Delayed revenue If your business has plenty of cash, this may not be an issue. However, if budgets are tight, delayed revenue could make it difficult to cover your operating costs.
  • Risk of buyer default Sometimes customers are unable to pay their debts. Depending on the trade credit agreement, there may be little to nothing the seller can do other than sell the debt to a collection agency at a fraction of the cost of the goods provided.  
  • Less profit with early payment discounts If the seller offers a discount for early payment, they will earn less on the sale than they otherwise would.

Trade Credit Accounting

Trade credit needs to be accounted for by both buyers and sellers. The process, however, will vary depending on the company’s accounting method — specifically, whether they use accrual vs cash accounting.With accrual accounting (which is used by all public companies), revenue and expenses are recorded at the moment of transaction, not when money actually changes hands. With cash accounting, on the other hand, a business records transactions at the time of making payments.A seller who offers trade credits and uses accrual accounting can face some complexities if the buyer ends up paying early and getting a discount or defaulting (and never paying). In this case, the amount received doesn’t match their account receivables and the difference becomes an account receivable write-off, or liability that must get expensed.Recommended: 9 Accounting Basics Every Small Business Owner Should Know

Trade Credit Instruments

Typically the only formal document used for trade credit agreements is the invoice, which is sent with the goods, and that the customer signs as evidence that the goods have been received. If the seller doubts the buyer’s ability to pay in the allotted time, there are credit instruments they can use to guarantee payment. 

Promissory Note

A promissory note, or IOU, is a legal document where the borrower agrees to pay the lender a certain amount by a set date. While it’s usually used for repaying borrowed money, it can also be used to pay for goods or services. 

Commercial Draft

One hitch with a promissory note is that it is typically signed after delivery of the goods. If a seller wants to get a credit commitment from a buyer before the goods are delivered, they may want to use a commercial draft. A commercial draft typically specifies what amount needs to be paid by what date. It is then sent to the buyer’s bank along with the shipping invoices. The bank then asks the buyer to sign the draft before turning over the invoices. After that, the goods are shipped to the buyer.

Banker’s Acceptance

In some cases, a seller might go even further than a commercial draft and require that the bank pay for the goods and then collect the money from the customer. If the bank agrees to do this, they must put it in writing — this document is called a banker’s acceptance. It means that the banker accepts responsibility for payment.

Trade Credit Trends

Trade credit is widely used worldwide. In fact, the World Trade Organization estimates that 80 to 90% of all world trade relies on trade credit in some capacity. It’s so widespread, it’s given rise to a type of financing called accounts receivable financing (also known as invoice financing). With invoice financing, a company that offers trade credit can get a loan based on their outstanding invoices, effectively enabling them to get paid early. When they receive payments from their customers, they give that money (plus a fee) to the financing company.

The Takeaway

Trade credit in business is very common and occurs when one company purchases goods or services from another company but doesn’t pay until a later date. Essentially an interest-free loan, trade credit can be particularly rewarding for young business or seasonal businesses that may find themselves occasionally strapped for cash. A key drawback of trade credit, however, is that the buyer is generally expected to pay the invoice relatively quickly, sometimes within a month or two. For many small businesses, that may not be enough time, and they might be better served by getting a small business loan.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
  3. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

Frequently Asked Questions

What is an example of trade credit?
Are there any benefits to trade credit?
When do businesses typically use trade credit?
Photo credit: iStock/AsiaVision
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About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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