What is Trade Credit? Here are the Advantages and Disadvantages

Without trade credit, cash goes out of your business when you buy stock or materials and comes in again when you sell to your customers. But with a trade credit agreement in place, you get the goods now, but keep your cash until payment is due days or weeks later. So, if you sell before that time, money comes in before it goes out. And, as long as you add value, more comes in than goes out.

But what is trade credit and how does it work? What are the advantages and disadvantages? Is it true that 80-90% of world trade relies on trade credit financing of some kind?

To answer the last of those first: Yes, according to the World Trade Organization. For a guided tour of what trade credit is and why it's important, read on.

What is trade credit in business?

In simple words, trade credit is when one business agrees with another to supply something now and let the other business pay later.

Let's go deeper now.

Trade credit is a two-way business transaction between a supplier and a buyer. Trade credit terms are agreed up front, often simply by one company deciding to do business with another. Usually, the supplier gives the buyer 30, 60 or 90 days to pay.

This means you get the goods up front without handing over any cash. You then use or sell these goods in your business and use the money you get from your customers as payment for the invoice you get from the supplier.

That's trade credit in a nutshell. Now let's look at how it works.

What is trade credit used for?

Cost control, cashflow management, financial leverage, capital release, financing for growth… Trade credit is the bedrock of business, the greatest facilitator of global and local trade from supermarket shelves to shipyards.

If you're on the receiving end, it's like having a short-term, unsecured, interest-free loan to buy the goods and materials you need. This puts assets in your hands that your business can use to generate income – with no drain on your working capital and a lot less pressure on your cashflow.

Some businesses simply couldn't exist without trade credit. Construction, shop-fitting, retail… Imagine having to pay for everything right away, all that cash tied up until the money comes in from your customers.

But there's another important side to trade credit. Most suppliers incentivise early payment to help their own cashflow. The deal might give you 90 days to pay, but a 2% discount if you pay within 14 days. This helps drive efficiency as you seek ways to create revenue sooner.

Terms may be negotiable. Heavyweight buyers might play one supplier's terms against another's. A start-up business might win round a supplier when bank loans aren't on offer. Buyers with seasonal demand might ask for a temporary increase in credit limit.

In finance, trade credit is a form of deferred payment. In business, it's the foundation of a mutually profitable relationship.

Trade credit advantages and disadvantages

As with any financial agreement, trade credit has both advantages and disadvantages, and these differ for buyers and suppliers. Trade credit can fuel growth, increase turnover, add a competitive edge and boost loyalty between collaborating businesses. But it can, in some cases, also expose suppliers to cashflow problems.

On balance, it's probably fair to say that trade credit works to everyone's advantage – as long as the risks are understood and properly managed. It's no surprise that larger businesses assign a dedicated credit manager to keep things on track and optimise the relationship.

What are the main advantages of trade credit?

• Eases cashflow for buyers
• Frees up working capital
• Discounts for early payments
• Lower operating costs
• Easy to set up
• Negotiating tool
• Builds relationships
• Fuels growth
• Gives a competitive edge
• Can help finance start-ups

Benefits galore for buyers, and not so shabby for suppliers either. Trade credit helps cement long-term partnerships. It gives both parties reason to pull together.

What are the main disadvantages of trade credit?

• Need for credit management
• Risk of late payment fees
• Potential supply chain complications
• May affect creditworthiness
• Some suppliers may refuse credit to start-ups
• Expensive if payment date is missed

The biggest downside to trade credit is the potential knock-on effect if things don't go to plan. For buyers, the penalty of failing to keep up your side of the deal can add to your costs and sour the relationship. But for suppliers, it could be far worse. If the customer business goes under and debts remain unpaid, suppliers can face an uncertain future.

What is credit insurance?

In some cases debt default can cripple a business. Credit insurance is designed to protect a supplier against excessive late payment or non-payment for goods or services supplied on credit.

Sadly, insolvency – where a business cannot pay its debts – is not uncommon. A credit insurance policy gives a supplier peace of mind that someone else's cashflow problems won’t have serious consequences for their own business.

Credit insurance can also help safeguard businesses from wider risks, such as fluctuations in international trade or government intervention in a business' sector.

Trade credit costs

While trade credit has no direct costs the way a bank loan does, there are indirect costs and a price to pay if things go awry. Here are a few things to consider:

• Pay your invoice on the due date and the credit shouldn't cost you any extra.
• If you don't take advantage of early payment discount, you're choosing to pay more to extend the credit period for longer.
• If you don't pay your invoices on time, you may be charged a penalty.
• You may need resources for credit management.
• Frequent late payment may lead a supplier to stop giving you credit, change the terms or refuse to do business with you.

Trade credit as a source of finance

For most businesses, trade credit has a part to play. But you should be aware that trade credit isn’t a long-term source of finance. The strength of the trade credit model is its repeatability factor. You get the goods, you add value, you sell and use the proceeds to pay your supplier's invoice.

More to read about Trade finance

• Letters of credit
• Reverse factoring
• Working capital
• Trade finance
• Forfaiting