Trade credit is the
loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that ...
extended by one trader to another when the
goods
In economics, goods are items that satisfy human wants
and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not ...
and
services are bought on
credit. Trade credit facilitates the purchase of supplies without immediate payment. Trade credit is commonly used by business organizations as a source of short-term financing. It is granted to those customers who have a reasonable amount of financial standing and goodwill. (Kuveya, 2020)
There are many forms of trade credit in common use. Various
industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives.
Trade credit is the largest use of capital for a majority of
business-to-business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. For example,
Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders.
Example
The operator of an
ice cream
Ice cream is a sweetened frozen food typically eaten as a snack or dessert. It may be made from milk or cream and is flavoured with a sweetener, either sugar or an alternative, and a spice, such as cocoa or vanilla, or with fruit such as ...
stand may sign a
franchising agreement, under which the
distributor agrees to provide ice cream stock under the terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10 days. This means that the operator has 60 days to pay the invoice in full. If sales are good within the first week, the operator may be able to send a cheque for all or part of the invoice, and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days, obtaining a 10% discount, or use the money for another 30 days and pay the full invoice amount within 60 days.
The ice cream distributor can do the same thing. Receiving trade credit from
milk
Milk is a white liquid food produced by the mammary glands of mammals. It is the primary source of nutrition for young mammals (including breastfed human infants) before they are able to digest solid food. Immune factors and immune-modulat ...
and
sugar
Sugar is the generic name for sweet-tasting, soluble carbohydrates, many of which are used in food. Simple sugars, also called monosaccharides, include glucose, fructose, and galactose. Compound sugars, also called disaccharides or do ...
suppliers on terms of
Net 30
Net 10, net 15, net 30 and net 60 (often hyphenated "net-" and/or followed by "days", e.g., "net 10 days") are forms of trade credit which specify that the net amount (the total outstanding on the invoice) is expected to be paid in full by the b ...
, 2% discount if paid within ten days, means they are apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would they do this? First, they have a substantial
markup on the ingredients and other costs of production of the ice cream they sell to the operator. There are many reasons and ways to manage trade credit terms for the benefit of a business. The ice cream distributor may be well-capitalized either from the owners' investment or from accumulated
profits, and may be looking to expand his
markets. They may be aggressive in attempting to locate new customers or to help them get established. It is not in their best interests for customers to go out of business from cash flow instabilities, so their financial terms aim to accomplish two things:
# Allow startup ice cream parlors the ability to mismanage their investment in
inventory
Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation.
Inventory management is a discipline primarily about specifying the sha ...
for a while, while learning their markets, without having a dramatic negative balance in their bank account which could put them out of business. This is in effect, a short term business
loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that ...
made to help expand the distributor's market and customer base.
# By tracking who pays, and when, the distributor can see potential problems developing and take steps to reduce or increase the allowed amount of trade credit he extends to prospering or exposure to losses from customers going
bankrupt who would never pay for the ice cream delivered.
Alternatives
One alternative to straightforward trade credit is when a supplier offers to give product on
consignment to a trader e.g. a gift shop. The terms of the arrangement mean that the original supplier retains ownership of the goods until the shop sells them.
Trade credit has been identified as a critical source of short-term financing for listed manufacturing companies. A trade credit contract is a legally binding agreement between two parties that allows a buyer to purchase goods or services on account and pay the supplier at a later date
See also
*
Discounts and allowances
*
Trade credit insurance
References
*Chludek, Astrid, K. (2010), p. 4
A note on the price of trade credit
{{Authority control
Credit
Accounting terminology
Working capital management