Trade credit
Encyclopedia
Trade credit is an arrangement between businesses to buy goods or services on account, that is, without making immediate cash payment. The supplier typically provides the customer
with an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should pay. It can be viewed as an essential element of capitalization in an operating business because it can reduce the capital
investment required to operate the business if it is managed properly. 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.
types of trade credits
For many borrowers in the developing world, trade credit serves as a valuable source of alternative data
for personal and small business loans.
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.
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 check 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 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
and sugar
suppliers on terms of Net 30
, 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 accumualated profits
, and may be looking to expand his market
s. They may be aggressive in attempting to locate new customers or to help them get established. It is not on their interests for customers to go out of business from cash flow instabilities, so their financial terms aim to accomplish two things:
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.
Customer
A customer is usually used to refer to a current or potential buyer or user of the products of an individual or organization, called the supplier, seller, or vendor. This is typically through purchasing or renting goods or services...
with an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should pay. It can be viewed as an essential element of capitalization in an operating business because it can reduce the capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
investment required to operate the business if it is managed properly. 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.
types of trade credits
For many borrowers in the developing world, trade credit serves as a valuable source of alternative data
Alternative data
In economic policy, alternative data refers to the inclusion of non-financial payment reporting data in credit files, such as telecom and energy utility payments. Only 39 of 178 economies have credit bureaus that currently track alternative data....
for personal and small business loans.
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.
Example
The operator of an ice creamIce cream
Ice cream is a frozen dessert usually made from dairy products, such as milk and cream, and often combined with fruits or other ingredients and flavours. Most varieties contain sugar, although some are made with other sweeteners...
stand may sign a franchising
Franchising
Franchising is the practice of using another firm's successful business model. The word 'franchise' is of anglo-French derivation - from franc- meaning free, and is used both as a noun and as a verb....
agreement, under which the distributor
Distributor
A distributor is a device in the ignition system of an internal combustion engine that routes high voltage from the ignition coil to the spark plugs in the correct firing order. The first reliable battery operated ignition was developed by Dayton Engineering Laboratories Co. and introduced in the...
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 check 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 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
Milk is a white liquid produced by the mammary glands of mammals. It is the primary source of nutrition for young mammals before they are able to digest other types of food. Early-lactation milk contains colostrum, which carries the mother's antibodies to the baby and can reduce the risk of many...
and sugar
Sugar
Sugar is a class of edible crystalline carbohydrates, mainly sucrose, lactose, and fructose, characterized by a sweet flavor.Sucrose in its refined form primarily comes from sugar cane and sugar beet...
suppliers on terms of Net 30
Net 30
Net 30 is a form of trade credit which specifies that the net amount is expected to be payment received in full 30 days after the goods are dispatched by the seller, or 30 days after the service is completed. Net 30 terms are often coupled with a credit for early payment; e.g...
, 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 accumualated profits
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
, and may be looking to expand his market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
s. They may be aggressive in attempting to locate new customers or to help them get established. It is not on their 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 inventoryInventoryInventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
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 loanLoanA loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
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 posure 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 consignmentConsignment
Consignment the act of consigning, which is placing any material in the hand of another, but retaining ownership until the goods are sold or person is transferred. This may be done for shipping, transfer of prisoners, to auction, or for sale in a store Consignment the act of consigning, which is...
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.
See also
- Discounts and allowancesDiscounts and allowancesDiscounts and allowances are reductions to a basic price of goods or services.They can occur anywhere in the distribution channel, modifying either the manufacturer's list price , the retail price , or the list price Discounts and allowances are reductions to a basic price of goods or services.They...
- Trade credit insuranceTrade Credit InsuranceTrade credit insurance, business credit insurance, export credit insurance, or credit insurance is an insurance policy and a risk management product offered by private insurance companies and governmental export credit agencies to business entities wishing to protect their balance sheet asset,...
- Suppliers Credit Related Articles
- Buyers Credit Related Articles