Trade credit is a financial arrangement where businesses can purchase goods or services on credit, paying later. It helps with cash flow and builds loyalty between buyers and suppliers.
What is Trade Credit?
Trade credit is a source of short-term financing. Of late in the business system, purchasers are not required to pay the value of goods by the time of purchase. Rather, they get the facility to pay the same after a particular period.
Thus for that particular period, it becomes a source of funds.
Definition of Trade Credit
L. J. Git man defines, “Trade credit is the credit granted by manufacturers, wholesalers, jobbers as an incident of sales.
According to J. F. Houston & E. F. Brigham, “Trade credit is an interim debt arising from credit sales and recorded as an account receivable by the seller and as an account payable by the buyer.”
Thus, trade credit is a credit where the seller arranges for temporary financing for the buyer through selling goods or services in credit.
Importance of Trade Credit as a Source of Working Capital
Easy availability
Trade credit can be obtained much faster and more easily than other sources of funds. Except for financially weak and less reputed businesses, all business organizations can obtain trade credit with a minimum of complexities.
Possibility of more profit by increasing sale
The main motive behind credit sales is to increase sales.
Most of purchasers prefer credit purchases to cash purchases. Moreover, if the terms of trade credit are relaxed, purchasers are even willing to pay higher prices. Thus a seller can increase his profit by selling in credit.
Fewer formalities
It requires very little formality in case of promissory note and trade acceptance, but there is no need to maintain any formalities in the open account system.
Financing volume
The volume of financing through trade credit depends on the volume of purchase and the time of paying the price.
As the firm increases its production and corresponding purchases, accounts payable increase and provide part of the funding needed to finance the increase in production.
Suppose a firm purchases $5,000 worth of goods a day from its suppliers in terms of ‘net 30’. The firm will thus be provided with $150,000 worth of financing from accounts payable (30 days X $5000 per day = $ 150,000) if it always pays at the end of the net period.
Now, if purchases from suppliers should increase to $6,000 per day, $30,000 of additional financing will be provided as the level of accounts payable ultimately rises to $180,000 (30 days X $6,000 per day).
Similarly, as production decreases, accounts payable tend to decrease.
Less Costly
If no cash discount is offered, there is no cost for the use of credit during the net period. On the other hand, if a firm takes a discount, there is no cost for the use of trade credit during the discount period. However, if a cash discount is offered but not taken, there is a definite opportunity cost.
No need for collateral securities
There is no need for collateral for financing through trade credit. The good business relationship between buyers and sellers, the sound financial position, and the reputation of the buyers act as security.
When the buyer is new or financially weak, the seller may require a deed of agreement or guarantee from a third party.
The benefit of the increased volume of credit
Trade credit represents a continuous volume of credit. There is no need to formally arrange to finance it is already there.
As old bills are paid and new credit purchases are made, new accounts payable replace old ones, and the amount of trade credit financing fluctuates accordingly.
Development of mutual trust and good relation
The base of trade credit is mutual trust and good relations between the buyer and the seller. Without trust and good relations, no one will sell goods in credit.
Credit sales and timely repayment create a relationship of mutual trust and understanding.
Flexibility
The lender and the debtor can increase or decrease the volume of credit according to their need and requirement. The buyer and seller can also change the terms of sale in response to any difficulty.
Moreover, there is no obligation on the part of either of the parties to take off grant credit.
Less risk of bad debt
In the case of credit sales, the seller carefully scrutinizes the ability and willingness of the buyer to repay the credit. There is less possibility of bad debt in relation which is the outcome of the repeated faithful transaction.
Only and last source for small traders
New and small businesses are reluctant to take bank or other institutional loans. Besides, traders in the villages who are less educated or uneducated are not capable of obtaining a bank loan.
Therefore, they start and conduct their business using trade credit.
The Formula for Finding the Approximate Cost of Trade Credit
The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases.
Because the supplier’s cost of having its money tied up in merchandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit.
The purchaser should, therefore carefully analyze credit terms to determine the best trade credit strategy. If a firm is extended credit terms that include a cash discount, it has two options;
- To take the cash discount, or
- Giving up the cash discount.
Taking the Cash Discount
If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no cost associated with taking a cash discount. But if we think the concept of opportunity cost then it has some specific cost.
Example: Lawrence Industries, operator of a small chain of video stores, purchased $ 1,000 worth of merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm rakes the cash discount, it must pay $980 [$ 1,000 – (0.02 x $ 1,000)] by March 10, thereby saving $20.
Giving Up the Cash Discount
Giving Up the Cash Discount If the firm chooses to give up the cash discount, it should pay on the final day of the credit period.
There is an implicit cost associated with giving up a cash discount. The cost of giving up a cash discount is the implied interest rate paid to delay payment of an account payable for an additional number of days.
Advantages of Trade Credit
Easy availability
Trade credit can be obtained much faster and more easily than other sources of funds. Except for financially weak and less reputed businesses, all business organizations can obtain trade credit with a minimum of complexities.
Possibility of more profit by increasing sale
The main motive behind credit sales is to increase sales. Most purchasers prefer credit purchases to cash purchases. Moreover, if trade credit terms are relaxed, purchasers are even willing to pay higher prices. Thus a seller can increase his profit by selling in credit.
Fewer formalities
It requires very little formality in the case of promissory notes and trade acceptance, but there is no need to maintain any formalities in the open account system.
Financing volume
The volume of financing through trade credit depends on the volume of purchase and the time of paying the price. As the firm increases its production and corresponding purchases, accounts payable increase and provide part of the funding needed to finance the increase in production.
Suppose a firm purchases $5,060 worth of goods a day from its suppliers in terms of ‘net 30’.
The firm will thus be provided with $150,000 worth of financing from accounts payable (30 days X $5000 per day = $ 150,000) if it always pays at the end of the net period.
Now, if purchases from suppliers should increase to $6,000 per day, $30,000 of additional financing will be provided as the level of accounts payable ultimately rises to $180,000 (30 days X $6,000 per day).
Similarly, as production decreases, accounts payable tend to decrease.
Less Costly
If no cash discount is offered, there is no cost for the use of credit during the net period. On the other hand, if a firm takes a discount, there is no cost for the use of trade credit during the discount period. If a cash discount is offered but not taken, however, there is a definite opportunity cost.
No need for collateral securities
There is no need for collateral for financing through trade credit. The good business relationship between buyers and sellers, the sound financial position, and the reputation of the buyers act as security. When the buyer is new or financially weak, the seller may require a deed of agreement or guarantee from a third party.
The benefit of the increased volume of credit
Trade credit represents a continuous volume of credit. There is no need to formally arrange to finance it is already there. As old bills are paid and new credit purchases are made, new accounts payable replace old ones, and the amount of trade credit financing fluctuates accordingly.
Development of mutual trust and good relation
The basis of trade credit is mutual trust and good relations between the buyer and the seller. Without trust and good relations, no one will sell goods on credit. Credit sales and timely repayment create a relationship of mutual trust and understanding.
Flexibility
The tender and the debtor can increase or decrease the volume of credit according to their need and requirement. The buyer and seller can also change the terms of sale in response to any difficulty. Moreover, there is no obligation on the part of either of the parties to take off grant credit.
Less risk of bad debt
In case of credit sales, the seller carefully scrutinizes the ability and willingness of the buyer to repay the credit. There is less possibility of bad debt in the relationship, which is the outcome of repeated faithful transactions.
Only and last source for small traders
New and small businesses are reluctant to take bank or other institutional loans. Besides, traders in the villages who are less educated or uneducated are not capable of obtaining bank loans. Therefore, they start and conduct their business using trade credit.
Disadvantages of Trade Credit
Shorter Repayment Period
In the case of trade credit, the buyer is allowed a very short time to repay the credit (generally 1 to 3 months), within which the credit may not be possible to be repaid.
Consequently, the mutual trust and good relationship between the buyer and seller may be handicapped, which may eliminate the possibility of any future transaction between them.
High Cost of Forgoing Cash Discount
Though trade credit does not have any cost, if there is an option for a cash discount benefit and the buyer forgoes that option, the opportunity cost of the trade credit exceeds the interest charged on institutional loans.
High Price of Goods
The buyer is ready to pay a higher price to avail of the facility of credit purchase.
Alternatively, the seller agrees to sell in credit if he is compensated at a higher price. Therefore, the credit sales price is generally higher than the cash sales price.
Possibility of Bad Debts Loss
When goods are sold on credit, there is a possibility of not realizing the entire price. Sometimes the buyer may be unable or even be reluctant to repay the credit. As there is no proper documentation of the credit sales in most cases, the seller is not able to take any legal action.
No Exemption of Tax
The interest on any loan is a deductible expense that provides a tax advantage or tax savings.
