What Are Trade Credits & How They Affect Business Finances

Trade credit is a common financial arrangement in business-to-business (B2B) transactions. It allows a business to receive goods or services from a supplier without immediate cash payment, agreeing to pay at a later, predetermined date. This arrangement acts as a form of short-term financing, distinguishing it from traditional bank loans that often involve interest charges and collateral requirements. Trade credit facilitates commerce and helps manage cash flow between companies.

The Mechanics of Trade Credit

The process of extending and utilizing trade credit involves a series of steps between the seller and the buyer. A business (buyer) wishing to acquire goods or services from a supplier (seller) first agrees on transaction terms. This agreement typically occurs before goods are shipped or services rendered.

Before extending credit, the seller assesses the buyer’s creditworthiness. This evaluation helps determine the likelihood of timely payment and manage potential risks. Factors considered include the buyer’s financial stability, past payment history, and references from other suppliers. Based on this assessment, the seller establishes a credit limit, the maximum amount of credit extended to that buyer.

Once terms are agreed upon and credit is approved, the seller delivers goods or services to the buyer. No immediate cash payment changes hands. The seller issues an invoice detailing items purchased, quantities, prices, and the total amount due, along with payment terms and the due date. The buyer records this obligation as an accounts payable, while the seller records the amount owed as an accounts receivable. The buyer pays the invoice on or before the specified due date, completing the trade credit cycle.

Common Payment Terms

Trade credit agreements commonly feature specific payment terms that dictate the repayment timeline and potential discounts. One prevalent term is “Net 30,” meaning full payment is due within 30 days from the invoice date. Similarly, “Net 60” extends this period to 60 days, and “Net 90” to 90 days. These “Net” terms signify the entire invoice amount is due by the specified number of days.

Another common term is “2/10 Net 30,” which includes an early payment discount. This means the full invoice amount is due in 30 days, but the buyer receives a 2% discount if payment is made within 10 days of the invoice date. This incentivizes buyers to pay earlier, improving the seller’s cash flow. The “2” represents the percentage discount, the “10” is the number of days within which payment must be made to qualify for the discount, and “Net 30” indicates the total credit period if the discount is not taken.

Occasionally, transactions may require “COD,” or Cash on Delivery. With COD, payment is due at the exact time goods or services are delivered. This term is typically used when a buyer has no established credit history or a poor payment track record, reducing the seller’s risk of non-payment. These terms provide flexibility in business transactions, allowing parties to manage their cash flows according to their operational needs and credit standing.

How Trade Credit Affects Business Finances

Trade credit influences the financial position and cash flow of both the buyer and the seller. For the buyer, it acts as an interest-free, short-term financing source, allowing them to acquire goods or services without immediate cash outlay. This deferral of payment directly impacts working capital by preserving cash for other operational needs or strategic investments. The amount owed to suppliers is recorded on the buyer’s balance sheet as accounts payable, a current liability.

From the seller’s perspective, extending trade credit means delaying the receipt of cash from sales, which affects their cash flow. The amounts owed by customers are recorded as accounts receivable, appearing as current assets on the seller’s balance sheet. While trade credit can boost sales by offering flexible payment options, it also ties up the seller’s capital in these receivables until payment is collected.

Effective management of accounts receivable is important for sellers to maintain sufficient liquidity and avoid cash flow constraints. For both parties, trade credit is a common component of working capital management, which involves optimizing current assets and liabilities to support day-to-day operations. While generally interest-free if paid on time, late payments can lead to penalties or interest charges, increasing the cost for the buyer and potentially straining relationships.