Trade credit (also known as trade finance) is a form of credit that is extended by B2B vendors to their customers. Because B2B purchases tend to be higher value than their B2C counterparts, arranging repayment terms can be beneficial to businesses that keep a close eye on their cash flow. Under a trade credit agreement, vendors will send an invoice for the outstanding amount, outlining the repayment terms. Payment is typically agreed upon within 30, 60 or 90 days, although in some cases, longer terms may be negotiated (e.g. if the buyer and seller have a good relationship, or the buyer has an excellent credit history).
Many small businesses use trade credit agreements as a form of interest-free trade finance. Because no interest is paid on the outstanding balance, it is advantageous when compared to financing the purchase with a bank loan or company credit card. However, buyers may be liable for late fees or interest payments if the balance is not settled within the agreed timeframe.
According to the World Trade Organisation, some 80-90% of all trade worldwide is facilitated by trade credit.
Example of trade credit
Now we know the definition of trade credit. But what might this look like in practice?
Company X purchases a machine with a value of £10,000 from its vendor, Company Y. The item will be dispatched before payment is received along with an invoice that contains clear terms for repayment. Because Company X has been buying from Company Y for years, they have negotiated repayment terms of 90 days. However, to incentivise repayment, Company Y offers a discount of 5% if payment is made within 30 days, and 2.5% if made within 60 days.
Company X is able to settle the balance in full within 45 days. This is advantageous for both parties, as Company X gets a £250 discount on its purchase, while Company Y is able to mitigate the cash flow risks inherent to creditors that offer trade credit to small businesses.
Trade credit accounting
Both buyers and sellers must properly account for trade credit. How they do this will vary, depending on whether they use the cash or accrual method of accounting.
Trade credit can complicate accrual accounting as sellers that offer it must recognise the revenue and expenses associated with the sale at the time of the transaction, rather than when payment is received. Because the company does not receive the cash straight away, the value of the transaction must be logged as accounts receivable on the company’s balance sheet.
Discounts for early repayment and defaults must also be logged as write-downs and write-offs respectively and considered liabilities that need to be expensed.
Frequently asked questions about trade credit
Why is trade credit beneficial for businesses?
Trade credit is beneficial for businesses as it enables them to make capital investments without putting a huge dent in their cash flow. In some cases, buyers may be able to negotiate longer repayment terms, ensuring that they can invest in improving their operations and potentially increase revenues before repayment is made.
What are the disadvantages of trade credit?
Trade credit can prove problematic for vendors. Although it may facilitate sales that would otherwise be lost, it can also result in a loss of operating cash flow. This is due to a sale being made, but the corresponding payment potentially not being received for several months. What’s more, vendors can be left seriously out of pocket if the buyer defaults on their agreement (e.g. goes out of business before the debt can be settled). This risk may be mitigated by trade credit insurance.
What is trade credit insurance?
Trade credit insurance covers businesses whose customers fail to make due payments, or make payments outside of the prearranged terms of the trade credit agreement. Cover can be used to mitigate commercial risk (when customers cannot pay due to insolvency) or political risk (when payment cannot be made due to factors outside the vendor or customer’s control).