'Trade Credit' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Trade credit refers to special financing terms which are many times given to a business by a supplier. This situation arises when a business buys supplies or goods and the financial officer or owner of the vendor agrees to provide either all or half of the purchased order on credit. In the case of half on credit, the balance half would become payable on delivery of the merchandise to the business.
When businesses receive a half order trade credit, they have several possibilities for paying for the balance on delivery. If they have ample resources, they can simply pay with cash. Otherwise, they can borrow the money to pay for the other balance on the inventory. This is why such credit remains among the most critical means of lowering the amount of working capital smaller businesses especially require. It is even more common and necessary with retail operations.
Suppliers normally extend such trade credit to a purchasing business once they have been a regular client for anywhere from 30 days, to 60 days, to 90 days. This trade credit has the advantage of being interest free. An example of this concept helps to make it clearer. Perhaps a supplier ships the Great Sweater Company knitted hats. The bill might normally be due within thirty days. Since Great Sweater Company enjoys these special credit terms, they would have an additional 30 days to cover the cost of the knitted hats which the vendor supplied.
When companies first start a new business, it is difficult to obtain such credit from the suppliers and vendors. In fact they will initially require each order to be paid by either check or cash on delivery. This will be the case until the new business demonstrates that it can successfully pay its bill in a timely fashion. It is a common practice in the business world. For those startups that need to raise money to make the operations work in the early days, it is important for them to be able to negotiate some form of this credit with their suppliers. It becomes easier earlier if the business owner can provide a well-developed financial plan.
It is important for businesses to properly utilize this trade terms credit. When they become trapped in the mentality of it being a necessary means of permanently financing the operations, then the business is in trouble. Instead it should be viewed as a useful source of funding for covering shorter term and smaller needs. This credit is not really a longer term solution to the funding problem.
For businesses who do not avoid this trap, they often times become heavily committed to working with the supplier who generously extends such trade credit terms. The end result of this is that the business is not able to choose a more aggressively competitive supplier that provides better prices, more timely deliveries, and/or a higher quality product because they do not offer such generous credit terms for their buyers. There is a trade off for everything in business.
It is important to realize that trade credit is rarely free. Every supplier may have its own terms. Yet most of them will provide a significant cash discount for those businesses that pay their invoices in 10 days or less. The same as cash price may be for 30 days. By waiting for the 30 days to pay the invoice, it is costing the business the two percent discount. If a business chose to do this for 12 months a year, it would mean the merchandise was costing an additional 24 percent versus the price of paying the 10 days same as cash terms.
When a business pays after the 30 days credit expires, most vendors charge from one to two percent interest in penalties. By being late for a year, this could cost an additional from 12 to 24 percent. This is why effectively utilizing trade credit means that a business will need to plan intelligently ahead so it does not lose cash discounts consistently or pay late fee penalties needlessly. Little details like this separate successful businesses from ones which fail.
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