What Is Trade Credit? - Definition, Formula & it's Benefits

With the overall growth of businesses in India, we have seen several transformations in and around the business environment. However, there are a few methods such as trade credit that have been in the practice since the inception of businesses. Trade credit is one of the most common short-term financing methods used by businesses. A good financial history and a strong financial statement for the business help in the smooth trade credit arrangement. It is not easy for a company with a poor financial statement and bad reputation to get a trade credit. 

To understand better, let us drive deep into the meaning, formula, features, and benefits of trade credit.

What is Trade Credit? Meaning & Example

Trade Credit occurs between two parties in a business where the supplier and customers can get involved in an agreement without any cash transactions. In the case of trade credit, no cash is transferred immediately.

For example, there are two companies involved in a transaction. Company A (buyer) and Company B (supplier) where company A buys goods from company B without paying any immediate cash or cheque and agrees to pay within 60 days of the transaction – such agreement is considered as trade credit.

Features of trade credit 

• In a Trade credit agreement, two parties are involved -- buyer and seller.
• The credit period is pre-decided by both the involved parties.
• It is influenced by factors such as the amount of credit, type of goods, and nature of the transaction between the two parties.
• It helps in improving the business’s cash flow.
• There is no interest charged or late fee in cases when payment is made on time.
• It is generally categorized under short-term debt with no or minimal interest charged.

Trade Credit Formula

Amount to be paid = Borrowed Amount x (1-discount)

For example, both parties have agreed upon a trade credit formula denoted as -- 2/10 Net 60

This means that the borrower gets a 2% discount if the balance is paid within 10 days from the date of issuance. If that does not happen, the borrower will have to pay the entire amount in full (without a discount) within 60 days from the date of issuance.

Also Read: Why Managing Working Capital is Important for Future Funding?

Benefits of Trade Credit 

Expansion of Business 

This is the best option for a company that doesn’t have the capital to make immediate payments to the supplier. With the use of trade credit, a business can easily arrange the raw material and start with the further process of production. This allows the business to have enough time to sell the goods and get payment from the customers. And money received from the customers can be used to make payments to the suppliers. It is the best possible method for a business to expand in the long run as it allows the business to constantly sell the goods and receive payment without putting too much pressure on them.

Flexible payment 

Trade Credit works on the relationship between the two involved parties. There are no strict rules for making payments as businesses are dynamic in nature. In a real-world scenario, the supplier gives enough time to make payment to the buyer as he knows the history of the buyer. As compared to other lending methods, trade credit is preferred by buyers due to its flexible payment method.

Interest Amount 

Interest is one of the main components of lending. As a borrower, you must pay interest on the amount that you have borrowed from the lender. Such interest is pre-decided between the lender and the borrower. However, in the case of trade credit, suppliers generally waive off the interest on the amount lent to the buyer as it is for a small duration and in virtue of maintaining a good relationship with the buyer.

Conclusion 

Trade Credit is good for businesses in the long run as it gives breathing space for the buyers to run their businesses smoothly. Also, it is highly dependent upon the trust and relationship between the supplier and the buyer. It will be difficult for a new buyer to get the same level of advantage as compared to an old or previous buyer. One of the major disadvantages of trade credit is in case the borrower fails to make timely payments to the customers due to any cash flow mismatch or in case of sudden low sales or low profit. Such scenarios hamper the relationship between suppliers and buyers and all future transactions.

Trade Credit FAQs

• What are the factors influencing the trade credit period?

7, 30, 60, 90, or 120 days are different trade credit periods offered by a lender. The trade credit period depends upon several factors such as the nature of the goods, the average rate of turnover of stock, the degree of competition, etc.

• How is trade credit beneficial for small businesses?

Small businesses run on small capital. Hence, there is a constant requirement for funds to meet the day-to-day expenses. Trade Credit helps small businesses to meet any short-term financial requirements such as purchasing inventory, paying bills etc.  

• Is trade credit expensive for small businesses?

Trade credit is not expensive for small businesses as there is no additional cost involved. In case the borrower fails to make payment on time. He will have to pay a late fee and charges for the late payment. Also, late payment can spoil the relationship with the creditors.

• What type of credit Is trade credit?

Trade credit is categorized under commercial financing where a borrower is allowed to purchase goods or services and make payment on the pre-decided date. Depending upon the requirement, you can try for short-term trade credit, intermediate trade credit, and long-term trade credit.

• What is the most effective way to use trade credit?  

Small businesses can use trade credit to fill the cash gap and make payments accordingly. Using trade credit, a company can purchase goods and sell them instantly. Later, repay the trade credit within the predecided schedule utilizing the discount payment offered by the lender.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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