Trade Credit is an understanding between companies and their suppliers/customers involved in business with each other. It helps in the transfer of goods and services between two parties without the immediate exchange of money. When the seller of a commodity or service has allowed the buyer to make the payment at a later date, the seller has extended Trade Credit to the buyer. This credit usually gets offered for a fixed number of days (like a week, month, six months or a year), but businesses can also extend it for a longer duration depending on the agreement between two parties.
The main features of Trade Credit are as follows:
- Treatment in the books of accounts – The Trade Credit that a firm extends to another business gets treated as an asset and it appears in the Accounts receivable. Similarly, the Trade Credit that a firm receives from another company gets treated as a liability and it comes under the Accounts Payable section.
- Short Term Debt – Trade Credit usually gets treated as a short term debt with no interest amount associated with it in most cases.
- Credit Period – The credit period is usually for a week, month, two months, six months or a year since it is not a long-term arrangement. But firms can also set the dates according to their convenience and the ability to pay back the loan amount. The credit period depends on several factors like the perishability of goods, the size of the account and the probability of the other party reneging on their commitment to pay.
The major benefits of Trade Credit are as follows:
- Expansion of the Business – Not every company can pay their supplier immediately because they may need money to finance the day-to-day operations of their firm. So if the supplier provides Trade Credit to a business, it gives them breathing space. They can use the raw materials provided by the suppliers to complete the production of their goods or services to sell in the market. The money received from the sale of those goods or services then gets used to pay the supplier. It helps firms to expand their business in the long run.
- Flexible Terms of Payment – The terms of payment in Trade Credit are very flexible compared to loans from banks or moneylenders. Since this transaction is based mainly on the relationship between the two parties, many of the strict conditions that banks or moneylenders have, while providing loans to a person, usually get waived off in Trade Credit.
- Interest Amount – Although the supplier has every right to charge interest on the Trade Credit they have extended to the other party, this requirement is generally waived off in such transactions. Since the supplier provided the loan for smaller durations, they leave the interest component out of this transaction. It is the main reason why many businesses prefer Trade Credit to take loans from banks or moneylenders.
Trade Credit is an essential part of any business. It is necessary for firms that do not have other means of financing their operations (raising capital through debt/equity financing or taking loans) available to them. It is also essential for firms that are either just starting out their business or operate on a much smaller scale.
Frequently Asked Questions
What are the factors that influence the credit period in Trade Credit?
Some of the factors that influence the credit period in Trade Credit are as follows:
- Nature of the Goods – If the goods are perishable in nature and cannot be sustained for a long period, then the seller may reduce the credit period.
- Size of the Account – If the account is not a huge business, the credit period will be shorter because it is costlier to manage smaller accounts.
- Creditworthiness – If the firm is providing credit to a high-risk business entity, the credit period and terms will be more stringent to ensure that they pay back the amount on time.
What are the Five Cs of credit?
The Five Cs of credit are Character, Capacity, Collateral, Capital and Conditions.