Trade credit is the most common source of spontaneous short-term finance for a business. In such an agreement, the seller is the lender, allowing the buyer to pay at a later date than it actually took possession of goods. Such a source of short-term finance is used to meet working capital needs. Trade credit is also very important for many businesses since they may have difficulties raising other sources of debt financing.
It is worth mentioning that sellers are usually the most loyal lenders compared with other lenders because sellers are always looking for an opportunity to boost sales, and selling on credit is the easiest way to do so. The downside, however, of extending credit to the buyers is taking the credit risk. In other words, a seller may have a loss if the buyer fails to pay an invoice.
Types of trade credit
- Open account
- Promissory note
- Trade acceptance
An open account is the most common type of trade credit that does not require the buyer to sign any additional formal document. In other words, an open account is an informal agreement. After the goods are shipped, the seller sends an invoice indicating the quantity of goods, total amount payable, and the due date. From this moment, the seller recognizes this amount as accounts receivable and the buyer as accounts payable.
A promissory note is a formal agreement signed by a buyer who is liable to pay a stated amount on the due date. It is often issued to extend an existing open account before its due date. The features of such an agreement are:
- It may have longer maturity than an open account
- Such a type of trade credit may bear some interest if payment is made after the due date
- If the issuer of a promissory note has high creditworthiness, it can be sold at a discount before the due date
The seller recognizes a promissory note as notes receivable and the buyer as notes payable.
Trade acceptance or a commercial draft is a formal document drawn by a seller and accepted by a buyer. Before goods are shipped, the seller draws a draft specifying the amount payable and the due date. Until the buyer accepts it, the seller will not ship the goods. If the buyer accepts the draft, it also designates the bank at which draft will be paid on the due date. Since the draft is accepted, it becomes a trade acceptance. The seller may collect it on the due date at a designated bank or sell it before the due date at a discount.
Trade credit occurs only if the seller allows payment for shipped goods later than the shipment date. In other words, the payment to be made by a buyer is deferred. We should designate two payment terms:
- Net period without discount. There is no discount for early payment before the due date. For example, a payment term “net 30” means that the buyer has to pay the invoice no later than 30 days.
- Net period with discount. The seller grants a discount for early payment. For example, a payment term “3/15, net 45” indicates that the buyer is eligible to get a 3% discount if the invoice will be paid within 15 days and is liable to pay the full amount not later than 45 days.
If the seller does not extend any early payment discount, the buyer incurs no cost related to using trade credit within the net period. If a discount is offered, however, the buyer incurs no cost only within the discount period. If it pays the invoice after the discount period, the opportunity costs arise.
The effective annual interest rate method should be applied to estimate the opportunity costs. The formula is as follows:
where T is a number of days in a year. It usually equals 365, but it also allows a 360-day year in accounting.
Let’s consider an example to better understand why opportunity costs arise if the buyer fails to pay within the discount period. Assume that the seller has shipped goods for $50,000 with a payment term “3/20, net 50.” If the buyer pays the invoice within the discount period of 20 days, it will get a discount of 3% or $1,500 ($50,000 × 3%). Therefore, the amount payable would be $48,500.
If the buyer does not take a discount, this $1,500 will be its opportunity costs. Let’s consider trade credit in terms of a loan. We can say that after the discount period the seller extends a loan of $48,500 to the buyer, who has to pay back $50,000 no later than the next 30 days. Thus, $1,500 can be treated as the interest expense of the buyer.
We should use the formula above to calculate the effective annual interest rate for using trade credit.
r = [3% / (100 – 3%)] × [365 / (50 – 20)] = 37.63%
If the buyer is able to raise short-term financing at a lower effective annual interest rate, it should take an early payment discount and pay for the goods at the end of the discounting period. Otherwise, if trade credit is the cheapest source of short-term financing available, the invoice should be paid at the end of the net period.
How to reduce costs of trade credit
As we can see in the example above, trade credit is a very expensive source of short-term financing. However, the bigger the difference between the net period and the discount period, the lower the effective annual interest rate. This relationship is presented in the figure below.
*the graph above is drawn for payment term “1/15, net X,” where X varies from 16 to 45 days
Please note that using trade credit within the first 15 days has no cost for the buyer!
If the net period is 16 days, the effective annual interest rate will be 368.69%.
r = [1% / (100 – 1%)] × [365 / (16 – 15)] = 368.69%
However, for a net period of 30 days, the cost of trade credit will be 24.58%.
r = [1% / (100 – 1%)] × [365 / (30 – 15)] = 24.58%
When the net period is extended to 45 days, it will already be only 12.29%. Thus, the longer net period, the cheaper the trade credit for the buyer.
Advantages and disadvantages
The advantages of trade credit are as follows:
- Quick to arrange. The buyer may easily arrange and maintain such an agreement as long as the conditions are met.
- No collateral required. The buyer is not supposed to provide to the seller any collateral or security.
- Flexibility. This source of spontaneous short-term financing meets the matching principle. In other words, the buyer raises financing exactly for that period and the amount it needs.
Please also note that trade credit remains the only source of short-term financing. This is especially true for new and growing businesses that are having trouble meeting the requirements of other creditors, e.g., banks.
However, using trade credit involves the following disadvantages:
- High cost. It usually has much higher costs than other sources of short-term financing, such as bank loans or lines of credit, because the credit risk is higher and no collateral is involved.
- Decrease in creditworthiness. As we have mentioned above, the longer the net period, the lower cost of trade credit, but this results in a growing balance of the “Accounts Receivable” account. In turn, it leads to an increase in current liabilities and a decrease in liquidity, which may be negatively perceived by other creditors.
- Indirect costs. As a rule, the cost of trade credit is included in the price of goods. In other words, the seller offers different prices for different payment terms. For example, cash on delivery usually assumes a lower price for the same goods than “net 30.” Higher prices compensate credit risk and higher financing costs of the seller.