Businesses without credit are hard to imagine. In today’s scenario, working capital and cash flow are some of the most significant aspects of business or trading (B2B).
The customers, especially, in B2B (Business 2 Business) want to purchase goods/ services on a credit basis without paying cash upfront.
Therefore, role of Trade Credit comes into picture and plays a vital role in B2B transactions.
This article intends to put forward what exactly is Trade Credit, and how important it is during B2B sales between two parties/ companies.
Table of Contents
Trade Credit – Definition
A Trade Credit also known as Tradeline or business credit is a credit facility availed by the supplier of goods/ services to their customers against the purchase of any goods/ services from them without paying upfront cash.
In other words, a Trade Credit refers to an arrangement/ agreement between buyers and sellers which provides liberty to the buyer to purchase goods/ services without paying cash upfront to the sellers.
However, the payment of such goods/ services shall be paid to the supplier at a future agreed date which typically ranges from 7, 14, 21 or 30, 45, 60, 90 days from the date of purchase (or date of receiving of goods) depending upon mutual understanding/ or negotiation.
Though some companies like Goldsmith offer even longer credit facilities to their customers. The companies may also offer a discount for payment prior to the due date in between a certain period of time.
Key Points –
- Trade Credit is a type of commercial financing without paying any interest to the supplier of goods or services and without the involvement of lending institutions.
- It works like buy now and pay later principal which facilitates in maintaining cash inflow for businesses.
- The ‘Account receivables’ in the supplier’s balance sheet denotes the trade credit extended by the suppliers, however, it denoted by Account payables in the balance sheet of the buyer firm’s balance sheet.
Credit Period –
Credit periods entirely depend upon industry to industry or customer to customer. The supplier assesses the credit period of any customer/ buyer based on the following perspectives.
- The most prominent factor that determines the credit period is the industry/ sector wherein the goods or services belong to. By means of which, if the demand for products/ services is high in the market, the credit period shall be shorter.
- The creditworthiness of the buyer is also a significant factor while determining a credit period. If the credit history of the buyer is outstanding, the suppliers won’t hesitate to assign a longer credit period.
- If the demand for products is less and the value of the product is high, in this case, suppliers have to provide comparatively longer credit to the buyers.
For example, in fast-moving sectors like FMCG the companies like HUL, P&G don’t provide any trade credit to their distributors (C&F) because their products are highly demanded in the market. So they don’t need to provide credit instead the retailers/ shopkeepers buy goods upon upfront cash.
Thus we can conclude that the duration of trade credit (credit period) also depends upon the industry and demand of products in the market and off course expiry of the product at the same time.
Trade Credit – Importance in Business
In domestic/ local transactions between two parties, there has always been a rush to increase sales and margin/ profit of supplier.
The competition among suppliers of generic items is increasing day by day in the local market. Hence retaining a customer for the long term has become hard. The customers not only demand a credit period but they also demand the products at the best possible rates.
Thus offering a trade credit has become compulsory these days, if you want to survive in business for the long run.
On the other hand, if we discuss from the buyer’s perspective, the trade credit has been an important tool to manage cash inflow and inventory of multiple items without any additional cost.
In addition, they get an additional time period to liquidate the items further to their customers/ consumers on a cash basis. Thus buyers don’t need to invest more funds to manage inventory.
In some highly competitive sectors like pharmaceuticals, the suppliers of medicines or companies bind to provide trade credit to their distributors/ retailers because of the high level of competition and profit margin. This is because, there are plenty of manufacturing companies of drugs, but marketing is a more important aspect of this industry. Therefore, the companies have to provide credit facilities for the distribution of drugs.
Cost of Trade Credit –
Since there is no involvement of any banks or other lending institutions to provide a trade credit. The supplier themselves offer such credit facilities to their regular customers to retain and increase sales.
Hence trade credit doesn’t put any cost (zero cost) to the buyers of goods or services, however, they might not be benefited from any discount (cash discount) offered by the sellers.
Some suppliers typically offer a discount if the buyer pays the dues within a certain time period, on the other hand, if buyers fail to make payment on the due date, some sellers might charge some interest (late payment charges) as well which depends on case to case basis.
For instance, suppose a company provides trade credit 2/10, net 30 days. That means the buyer obligated to pay the bills before 30 days and if he makes payment within 10 days, he will get a discount of 2%.
Advantages of Trade Credit –
As we discussed above, the advantages of trade credit are mostly for the buyers. Some of the major benefits are as follows.
- Buyers don’t need to invest extra funds for inventory management.
- Trade Credit facilitates in achieving positive cash flow without any additional efforts.
- The buyers can buy the goods or services without paying upfront cash.
- The buyers don’t need to arrange more funds for the expansion of the business.
- It facilitates in pushing sales and an overall turnover of the company.
- Suppliers have the opportunity to build strong relationships with the customers.
- Supplier is able to retain their customers for the long term.
- The supplier might sell their products relatively at a higher price to their loyal customers by offering a credit facility.
Disadvantages of Trade Credit –
- Buyers usually purchase goods at higher rates because they miss the opportunity of cash discounts.
- Buyers might have to pay extra money if they won’t pay the dues on time.
- Buyers sometimes bound to purchase goods or services from particular sellers only.
- Buyers can’t negotiate rates of products with sellers as much as they can.
- Bad debts and Delayed payment are few major disadvantages of trade credit for sellers.
- Increased number of bad debts can lead to even a loss to the sellers.
- Trade credit can negatively affect the cash inflow for businesses if the receivables are not paid off on time.
- The suppliers not only have always the risk of non-payment but also lose their customers forever due to arrears.
- The supplier sales may be compromised because of unpaid bills and lead to a cash crunch for small
How to analyse credit of a buyer?
Whether you are a supplier/ firm or working in a company as a sales person, the credit analysis is a vital task while determining a trade credit time period.
You can follow the following assessment criteria to judge the creditworthiness of any buyer/ company.
1) Financial Statement –
The financial statement of a company/ firms can reveal actual conditions of the buyer’s firm. So you should critically analyse its financial statements before supplying goods or assigning credit.
2) Credit History –
The credit history of buyer with other firms may help you to understand the nature, character and attitude of buyers. You can gather feedbacks from other suppliers like you to come up with the decision whether the buyer is loyal or not.
3) Banks –
The banks may also assist to acquire information regarding credit history of the firms. You can simply take feedback from the buyer’s bank to assess the creditworthiness.
4) 5C Principle –
The 5C principal help you to understand credibility of buyer quickly.
- Character – The character of buyers is more important than anything else because if the buyer’s intention is not to pay the due, what else can let him to do so.
- Capacity – The capacity of buyer is also important because if his intention is to pay but he is not capable enough to pay, so what can anyone do in this matter.
- Capital – If a buyer has enough capital/ reserve funds, he can surely meet his obligations.
- Collateral – It’s like a safeguard for sellers, a buyer shall have to pay if he purchased the goods against a collateral, otherwise, sellers is free to recover his payment from the collateral.
- Condition – Current condition of the buyers is extremely important. Even if he has passed all above prerequisite, but current condition should be final in determining credit.
In the real world, a business without credit is very difficult to survive. So trade credit becomes an important aspect of any kind of businesses. However, it provides more facility to the buyer’s side, but it also assists the suppliers of goods as well.
There are lots of examples of trade credit these days, even top multinationals utilize such credit facilities in the market.
In a nutshell, it is a zero financing short-term credit facility for the buyers which helps them to manage inventory without any additional cost. Even a company like Walmart utilizes trade credit to manage their inventory and the suppliers shall get paid only if their products have been sold off.