Trade credit is an essential concept that helps businesses maintain smooth operations without the pressure of immediate payments. By allowing buyers to defer payment for goods or services, trade credit enables companies to bridge the gap between outgoing expenses and incoming revenue. For many businesses, especially small and medium-sized enterprises, this can be a lifeline, ensuring that they can continue to operate while waiting for their own receivables to come in.
Unlike traditional loans, trade credit is a more flexible and relationship-based form of financing. Suppliers trust that buyers will fulfill their obligations within an agreed-upon timeframe, often without involving formal financial institutions. This arrangement fosters a sense of mutual support between businesses, making trade credit a powerful tool for building long-term partnerships in the supply chain.
However, the nature of trade credit is not without its complexities. While it offers significant advantages, there are risks involved for both parties, particularly when it comes to managing payment terms and cash flow. Understanding how trade credit works and its role in financial planning is crucial for any business looking to maintain stability and growth.
How trade credit works
Simply put, trade credit is an agreement between two businesses: the buyer receives goods or services immediately but agrees to pay the supplier at a later date. These payment terms usually range from 30 to 90 days, although they can vary depending on the relationship between the buyer and supplier or the industry standard. The terms are typically expressed as “Net 30,” “Net 60,” or “Net 90,” indicating the number of days the buyer has to make full payment.
For example, a company may purchase inventory from a supplier with a 60-day payment term. This means the buyer takes possession of the goods right away but doesn’t need to pay for them until two months later. This delay allows the buyer to potentially sell the inventory, generate revenue, and use that cash flow to settle the debt without needing upfront funds.
Trade credit is often extended based on the buyer’s creditworthiness and the trust established between the two parties. Businesses that pay their invoices on time are more likely to be offered favourable terms in the future, while those who default or delay payments may face stricter conditions or lose access to trade credit entirely.
Types of trade credit
Trade credit comes in various forms, offering businesses different ways to manage payments based on their needs. The most common type is open account credit, where goods or services are delivered, and the buyer is billed with a due date for payment. This form of credit relies heavily on trust, as there are no formal agreements beyond the invoice terms. It’s widely used because it’s straightforward and doesn’t involve complex paperwork.
Another type is the promissory note, which adds a layer of formality to the transaction. In this arrangement, the buyer signs a legal document promising to pay the agreed-upon amount within a specific period. While this might seem like a simple guarantee, it offers the supplier more security, especially in situations where large sums are involved or where the buyer’s creditworthiness is uncertain.
Trade acceptance is another option, typically used in international trade. Here, the buyer accepts a bill of exchange—a written order requiring them to pay a specified amount at a future date. Once the buyer accepts this document, it becomes a binding promise to pay, adding a legal obligation to the transaction. Each type of trade credit serves different purposes and can be tailored to fit the specific needs of the businesses involved.
Advantages of trade credit
Trade credit is a great way for businesses to manage their cash flow more easily. It lets them delay payments, so they can use their money for immediate needs like paying employees, covering day-to-day expenses, or investing in growth. This is especially helpful for businesses with longer sales cycles or seasonal revenue since it gives them some breathing room until their income catches up with their costs.
Another big advantage of trade credit is that it can help build stronger relationships between buyers and suppliers. When suppliers offer flexible credit terms, they’re seen as partners who are helping to ease financial strain. This often leads to long-term relationships based on trust and mutual benefit. In industries where having a reliable supply chain is fundamental, these partnerships can become a real competitive advantage.
Trade credit is also a budget-friendly alternative to traditional financing options like bank loans or lines of credit. It usually doesn’t involve interest, as long as payments are made within the agreed terms, which helps businesses save on extra costs. For companies that want to expand without taking on debt, trade credit is an appealing choice.
Industry-specific benefits
Trade credit serves as a key financing mechanism across various industries and countries, influencing investment and economic performance. Its benefits, however, vary significantly based on industry characteristics and national contexts.
According to a paper on ScienceDirect from Carroll & Neumann, industries with a higher propensity to utilise trade credit, such as manufacturing, experience greater investment shares when international trade credit is accessible.
The paper reveals that access to trade credit positively influences investment decisions, allowing companies to finance new projects and expand their operations.
Trade credit serves as an informal financing mechanism, reducing the need for short-term borrowing from financial institutions. Manufacturers, for example, often depend on these credit terms to buy raw materials, produce goods, and maintain operations before sales revenue starts flowing in. In international trade, access to credit from overseas suppliers can boost a company’s ability to grow, helping them enter new markets or increase production to meet global demand.
This dynamic illustrates why industries with a strong reliance on trade credit, like manufacturing, tend to benefit more from its availability. When international trade credit is accessible, it creates a supportive financial environment that allows these companies to make strategic investments, driving growth and innovation.
Country-level implications
Let’s take a look at the market in the UK and Ireland.
According to a paper from Eurasian Economic Review, (Trade credit, trade income elasticity and the international transmission of shocks by Anna Watson, 2021) trade credit is a major source of short-term financing for businesses in the UK and Ireland, especially for exporters. The data shows that 75% of exporters use trade credit, compared to 63% of non-exporting firms.
The most common type of trade finance in these areas, according to the paper, is open account financing, making up about 40% of transactions. In this setup, exporters extend credit to importers and take on the risk of non-payment. Another 20% of transactions use cash-in-advance, where importers provide trade credit to exporters.
The research provides evidence that trade credit significantly contributes to the high trade income elasticity observed in the data. This means that changes in income levels have a pronounced effect on trade volumes, particularly for exporters who rely heavily on trade credit.
The findings come from a detailed analysis of firm-level data from the 60,000 largest companies in the UK and Ireland, which account for over 99% of total revenue and employment in the corporate sector. This extensive dataset provides a strong basis for examining the differences in trade credit use between exporters and non-exporters.
Debunking common misconceptions about trade credit
When it comes to trade credit, many businesses either misunderstand its value or hesitate due to common myths that surround it. Let’s clear up and debunk some of the biggest misconceptions:
- Myth 1: “Trade credit is always a risk for suppliers.”
The Reality: Although offering trade credit comes with risks—like late or missed payments—these can be managed with the right credit practices. Suppliers can evaluate their buyers’ financial health, set clear payment terms, and even use trade credit insurance for extra protection. Many suppliers see trade credit not just as a risk, but as a way to build lasting relationships and expand their customer base.
- Myth 2: “Only large businesses can benefit from trade credit.”
The Reality: Trade credit isn’t just for big companies. Small and medium-sized businesses (SMBs) often use it to keep their cash flow steady, handle seasonal demands, or grow their operations. In fact, by offering or using trade credit, small businesses can gain an advantage, helping them expand without needing a lot of upfront cash.
- Myth 3: “Trade credit is too complicated for small businesses to manage.”
The Reality: Thanks to technology, managing trade credit is now simpler than ever. There are software tools that automate things like credit checks, invoicing, and tracking payments. Plus, services like trade credit insurance and factoring can help small businesses cut down on the hassle and financial stress of providing or using trade credit.
- Myth 4: “If a customer requests trade credit, they must be struggling financially.”
The Reality: While some businesses turn to trade credit during cash flow problems, many financially stable companies use it as a smart strategy. Whether or not a company is in good financial shape, trade credit helps them keep cash on hand, invest in growth, or improve cash management. Using trade credit often shows a company’s financial savvy, not a sign of struggle.
- Myth 5: “Extending trade credit means waiting forever to get paid.”
The Reality: Payment delays are a common issue, but they can be handled with the right approach. Clear terms, rewards for early payments, and invoice tracking software can help prevent long delays. Additionally, trade credit terms can be customised—what works for one business might not work for another. Shortening payment cycles or adding late fees can also help keep cash flow steady.
How to set up trade credit in your business?
Follow our 8-step guide:
1. Evaluate your business’s financial health
- Before offering trade credit, ensure your business has a solid cash flow and financial stability. You’ll need to absorb delayed payments, so make sure you can maintain your operations without immediate cash inflow.
- Tip: Use a cash flow projection tool to see how delayed payments could affect your business.
2. Define credit terms
- Decide the conditions for offering trade credit. Common options include:
- Net 30/60/90: Payment is due within 30, 60, or 90 days.
- Early Payment Discounts: Offer discounts for early payment, such as 2% off if paid within 10 days (2/10 Net 30).
- Tip: Keep terms simple and clear to avoid confusion or disputes.
3. Assess creditworthiness
- Establish criteria for determining which customers can qualify for trade credit. You may use financial statements, credit reports, or past payment history to assess creditworthiness.
- Sample Criteria:
- Minimum annual revenue
- Positive credit history with no defaults
- Established business relationship for at least 6 months
4. Draft a credit application form
- Create a simple credit application form to collect necessary information from customers. This form should include:
- Business name and registration details
- Financial history and credit references
- Authorised signatories
5. Establish a credit limit and terms of sale
- Set limits based on the customer’s financial situation and history. Typically, start with lower amounts and increase them over time as they prove their ability to pay.
- Sample Trade Credit Terms:
- Credit Limit: $10,000
- Payment Terms: Net 30 days
- Early Payment Discount: 2% if paid within 10 days
- Late Payment Penalty: 1.5% per month on overdue balances
6. Use contracts and agreements
- A written agreement is critical to protect both parties. This contract should outline the credit terms, including any late payment penalties or other conditions.
7. Monitor payments and follow up
- Keep a close watch on due dates and late payments. Establish a system for tracking receivables, and send reminders before payment is due. If payments become overdue, send follow-up notices or phone calls to resolve issues quickly.
8. Review and adjust terms periodically
- Review the performance of your trade credit system regularly. If a customer is consistently late with payments, you may need to reduce their credit limit or move them to cash terms.
- Similarly, if a customer has a strong payment history, you might consider increasing their credit limit or extending more favourable terms.
To sum up
Trade credit is a vital part of business finances, offering flexibility, strengthening relationships, and serving as an alternative to traditional loans. For buyers, it helps manage cash flow, while for suppliers, it can create lasting partnerships. However, like any financial tool, it comes with risks that need to be managed carefully. Late payments, defaults, and poor credit practices can cause more problems than benefits if not handled properly.
In the end, acknowledging how trade credit affects your business’s financial health is key to using it effectively. For those companies that find the right balance, trade credit can be a powerful tool for growth and stability, helping ensure smooth operations in both the short and long term.
