19.2 What Is Trade Credit?
3 min read•june 18, 2024
is a crucial short-term financing tool for businesses. It allows companies to buy goods or services now and pay later, impacting and cash flow. Understanding the costs, benefits, and risks of trade credit is essential for effective financial management.
, credit periods, and trade-offs in all play vital roles in trade credit arrangements. These factors influence payment timing, supplier-customer relationships, and overall financial health. Balancing the advantages of delayed payment against the costs of forgoing discounts is key to optimizing trade credit usage.
Understanding Trade Credit
Cost of trade credit
Top images from around the web for Cost of trade credit
Math. Sc. UiTM Kedah: Trade and Cash Discount View original
Is this image relevant?
Working Capital Management Strategies in Polish SMEs View original
Is this image relevant?
Differential Effects of Received Trade Credit and Provided Trade Credit on Firm Value - Vivek ... View original
Is this image relevant?
Math. Sc. UiTM Kedah: Trade and Cash Discount View original
Is this image relevant?
Working Capital Management Strategies in Polish SMEs View original
Is this image relevant?
1 of 3
Top images from around the web for Cost of trade credit
Math. Sc. UiTM Kedah: Trade and Cash Discount View original
Is this image relevant?
Working Capital Management Strategies in Polish SMEs View original
Is this image relevant?
Differential Effects of Received Trade Credit and Provided Trade Credit on Firm Value - Vivek ... View original
Is this image relevant?
Math. Sc. UiTM Kedah: Trade and Cash Discount View original
Is this image relevant?
Working Capital Management Strategies in Polish SMEs View original
Is this image relevant?
1 of 3
- Trade credit is short-term financing offered by suppliers to customers enables purchasing goods or services on account and paying later
- represents the implicit interest rate for not taking early payment discounts calculated using the formula: where is days between end of and final due date
- Trade credit impacts working capital by increasing (current liability), potentially decreasing cash if discounts are taken, and increasing inventory levels for goods purchased on credit (raw materials, finished products)
Role of cash discounts
- incentivize early payment by offering a percentage off the invoice amount typically expressed as "2/10, net 30" meaning 2% discount if paid within 10 days, otherwise full amount due in 30 days ()
- Cash discounts play a key role in trade credit agreements by encouraging customers to pay early which improves supplier's cash flow, reduces risk of late payments or defaults for the supplier, and provides savings opportunities for customers on their purchases (bulk orders, regular shipments)
Impact of credit periods
- is the timeframe for taking advantage of early payment discounts shorter periods encourage faster payments and improve supplier's cash inflow, while longer periods provide customer flexibility but may delay supplier's cash inflows
- is the total time allowed for payment including the discount period longer periods give customers more time to pay but can strain supplier's cash flow, while shorter periods reduce late payment risk but may be less attractive to customers
- Businesses must balance offering favorable terms to customers with maintaining healthy cash flow too generous terms can cause cash flow problems for suppliers, while overly strict terms may deter potential customers or strain existing relationships (long-term contracts, large accounts)
Trade-offs in credit terms
- Accepting trade credit terms:
- Conserves short-term cash by delaying payments
- Provides flexibility in managing cash flow and working capital
- Enables purchasing more inventory or investing in growth
- Forgoing early payment discounts results in higher overall costs
- Forgoing trade credit terms:
- Requires upfront payment for purchases which may strain cash flow
- Allows taking advantage of early payment discounts reducing effective purchase costs
- Improves supplier relationships by showing financial stability and reliability
- Limits ability to invest in growth or manage short-term cash needs
- Businesses must carefully consider their financial situation, cash flow needs, and supplier terms when deciding to accept or forgo trade credit weighing the benefits of short-term cash conservation against the costs of missing discounts and potential impact on supplier relationships (negotiation, volume commitments)
Managing Trade Credit Risk
- Suppliers must assess when offering trade credit to customers, considering factors such as payment history and financial stability
- Businesses can use management techniques to monitor and collect payments from customers using trade credit
- programs can help optimize cash flow for both suppliers and customers in trade credit arrangements
- can protect suppliers against non-payment risks associated with offering credit terms to customers
Key Terms to Review (31)
Accounts Payable: Accounts payable refers to the short-term debt obligations a company owes to its suppliers or vendors for goods and services received. It represents the amount a company owes to its creditors and is a crucial component of a company's working capital and cash flow management.
Accounts Receivable: Accounts receivable refers to the money owed to a company by its customers for goods or services provided on credit. It represents the outstanding balance that customers have yet to pay for their purchases, and it is considered a current asset on the company's balance sheet.
Accounts receivable aging schedule: An accounts receivable aging schedule is a report that categorizes a company's accounts receivable according to the length of time an invoice has been outstanding. It helps businesses identify overdue payments and manage credit risk.
Bill of lading: A bill of lading is a legal document issued by a carrier to acknowledge receipt of cargo for shipment. It serves as a shipment receipt, a document of title, and a contract between the shipper and the carrier.
Cash discounts: Cash discounts are reductions in the invoice price offered by sellers to encourage early payment from buyers. These discounts benefit both parties by improving cash flow for sellers and reducing overall costs for buyers.
Cash Discounts: Cash discounts refer to the reduction in the price of a product or service offered by a seller to a buyer who pays the full amount within a specified time period, typically a short duration. This practice is commonly used in trade credit transactions to incentivize prompt payment and improve cash flow for the seller.
Commercial Paper: Commercial paper is a short-term, unsecured debt instrument issued by corporations and other entities to raise funds for their immediate operational needs. It is a flexible and cost-effective way for companies to manage their cash flow and meet their short-term financial obligations.
Commercial paper (CP): Commercial paper (CP) is an unsecured, short-term debt instrument issued by corporations to finance their immediate needs. It typically has a maturity period of up to 270 days and is usually issued at a discount from face value.
Cost of Trade Credit: The cost of trade credit refers to the implicit or explicit expenses incurred by a business when it purchases goods or services on credit from its suppliers. This cost is an important consideration in the overall financial management of a company's working capital and cash flow.
Credit period: The credit period is the length of time a seller allows a buyer to pay for goods or services purchased on credit. It typically ranges from 30 to 90 days depending on industry standards and the agreement between parties.
Credit Period: The credit period, also known as the credit term or payment term, refers to the length of time a customer is granted to pay for goods or services purchased on credit. It is a crucial aspect of trade credit, which involves the extension of short-term financing from a supplier to a customer.
Credit risk: Credit risk is the possibility of a borrower failing to repay a loan or meet contractual obligations. It affects lenders and investors as it impacts the expected returns on investments involving debt instruments.
Credit Risk: Credit risk is the risk of loss arising from a borrower's failure to repay a loan or meet contractual obligations. It is a fundamental consideration in the context of bonds, trade credit, and receivables management, as it can significantly impact the value and performance of these financial instruments and transactions.
Credit Terms: Credit terms refer to the conditions and agreements set by a seller or lender when extending credit to a buyer or borrower. These terms outline the details of the credit arrangement, such as the payment due date, interest rates, and any penalties or fees associated with late or missed payments.
Creditor Turnover Ratio: The creditor turnover ratio is a financial metric that measures how efficiently a company manages and pays its accounts payable, or the money it owes to its suppliers and other creditors. It provides insight into a company's working capital management and liquidity.
Days Payable Outstanding: Days payable outstanding (DPO) is a financial metric that measures the average number of days a company takes to pay its suppliers or creditors. It provides insight into a company's working capital management and trade credit practices.
Discount period: A discount period is the timeframe within which a buyer can pay an invoice to receive a discount on the total amount due. It incentivizes early payment and helps suppliers manage cash flow more effectively.
Discount Period: The discount period refers to the time frame during which a buyer can take advantage of a discount offered by a seller for early payment of an invoice or account receivable. This term is particularly relevant in the context of trade credit, where businesses extend short-term financing to their customers in the form of delayed payment terms.
Gross working capital: Gross working capital is the total value of a company's current assets, which are assets that are expected to be converted into cash within one year. It includes cash, accounts receivable, inventory, and other short-term assets.
Letter of credit: A letter of credit is a financial document issued by a bank guaranteeing a seller's payment will be received on time and for the correct amount. If the buyer fails to make the payment, the bank covers the full or remaining amount of the purchase.
Letter of Credit: A letter of credit is a document issued by a bank that guarantees payment to a seller upon presentation of documents that conform to the letter's terms and conditions. It serves as a means of facilitating international trade by providing security for both the buyer and the seller.
Net terms: Net terms are payment terms offered by a seller to a buyer that extend the period for invoice payment without penalties. Commonly, these terms range from 30 to 90 days.
Net Terms: Net terms refer to the credit period or payment timeline granted by a supplier or vendor to a customer for the purchase of goods or services. This credit arrangement allows the customer to pay for the transaction at a later date, typically within a specified number of days, rather than requiring immediate payment.
Open Account: An open account is a trade credit arrangement where a seller extends credit to a buyer, allowing the buyer to make purchases and pay for them at a later date, typically within a specified time period, without requiring a formal contract or loan agreement.
Pecking Order Theory: Pecking order theory is a concept in corporate finance that describes the order in which a company will prefer to use sources of financing for new investments. It suggests that companies prioritize internal financing over external financing, and if external financing is required, they will prefer debt over equity.
Promissory Note: A promissory note is a written promise to pay a specified amount of money to another party by a certain date. It is a legally binding contract that outlines the terms of a loan, including the repayment schedule and interest rate, if applicable.
Quick payment: Quick payment is the prompt settlement of an invoice or debt, often within a specified period. It usually involves taking advantage of early payment discounts offered by suppliers.
Supply Chain Finance: Supply chain finance refers to the set of solutions and technologies that optimize and accelerate the flow of financial transactions and information within a supply chain. It aims to improve the financial efficiency and liquidity of the entire supply chain ecosystem by providing financing options and managing financial risks.
Trade Credit: Trade credit refers to the credit extended by a supplier to a business customer, allowing the customer to purchase goods or services and pay for them at a later date. This type of short-term financing is a common practice in commercial transactions, providing flexibility and convenience for both the supplier and the customer.
Trade Credit Insurance: Trade credit insurance is a type of commercial insurance that protects businesses from the risk of non-payment by their customers. It provides coverage for accounts receivable, ensuring that companies can recover a portion of their unpaid invoices in the event of a customer's insolvency or default.
Working Capital: Working capital refers to the difference between a company's current assets and current liabilities, representing the liquid resources available to fund day-to-day business operations. It is a crucial metric that reflects a company's short-term financial health and liquidity position, with implications across various financial statements and analysis techniques.