Trade credit definition
/What is Trade Credit?
Trade credit is an arrangement between a seller and a buyer, where the seller allows the buyer to make purchases now and pay at a later date without incurring an interest charge. It is essentially a form of zero-interest financing for buyers. This arrangement allows the buyer to sell the goods and earn sufficient cash to pay off its debt to the seller. Common time periods for the extension of trade credit are for buyers to pay in 7 days, 30 days, 60 days, or 90 days after the shipment date.
Advantages of Trade Credit
A seller may offer trade credit for several reasons, including the ones noted below:
Industry practice. It may be accepted practice within an industry to offer buyers a certain number of days in which to pay, such as 30 days from the shipment date. If a seller does not offer the standard industry terms, then it may have quite a hard time attracting any customers.
Competitive posture. A seller may offer unusually long payment terms in order to increase its sales to customers that value such terms. However, this offering is more likely to increase sales to customers that are in poor financial condition, which increases the risk of incurring bad debts. Nonetheless, the extension of more trade credit is a way to increase a firm’s market share.
Customer support. Customers may be suffering during an industry downturn, so the seller offers them extended trade credit in order to keep them afloat. By doing so, the seller retains a base of customers and earns their goodwill, which may translate into increased customer loyalty over an extended period of time. This is especially the case when the seller is willing to extend payment terms substantially when a customer is working through a difficult financial stretch.
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How to Manage Trade Credit
A seller does not usually allow more than a minimal amount of trade credit to a new and unproven customer. Instead, new customers must prove their financial reliability with a series of timely payments, as well as by forwarding their audited financial statements to the seller. Once a payment history has been established, the amount of trade credit offered to a customer will be gradually increased to cover its ongoing purchases from the seller.
If a buyer does not pay the seller within the prescribed time period, the seller may restrict the amount of trade credit allowed, and may also require the buyer to pay an interest charge or late fee. When a customer significantly abuses trade credit terms, the seller might put it on cash-on-delivery terms instead, thereby reducing the seller’s risk of nonpayment to zero.