What is trade credit?

Trade credit is a vital component of modern business transactions, offering a mutually beneficial financing solution for both suppliers and buyers. It is an essential financial tool that facilitates the exchange of goods and services on credit terms, allowing companies to manage cash flow effectively, enhance relationships with business partners, and stimulate economic growth. In this essay, we will provide a comprehensive overview of trade credit, explain its key concepts, offer examples from prominent companies, and present statistics that highlight its significance in the business world.

I. What is Trade Credit?

Trade credit, often referred to as supplier credit, is an arrangement between two businesses where one company (the supplier) provides goods or services to another company (the buyer) on credit terms. The buyer agrees to pay for the products or services at a later date, typically after a specified period, which can range from 30 to 90 days, or even longer. This credit extension can take several forms, including open account credit, revolving credit, and installment credit.

1. credit Terms: Credit terms are a cornerstone of trade credit agreements. These terms define the agreed-upon payment schedule, specifying when the buyer is obligated to settle the outstanding invoice. Payment terms are often expressed using the “net” framework, such as “Net 30,” “Net 60,” or “Net 90.” In these examples, the number indicates the days within which the buyer is expected to remit payment after receiving the goods or services. For instance, “Net 30” requires payment within 30 days of invoice receipt.
2. Credit Limit: Suppliers frequently establish credit limits for their buyers. These limits are influenced by the creditworthiness of the purchasing company. A supplier may assess the financial stability and history of the buyer before determining the maximum credit amount they are willing to extend. Buyers who demonstrate a strong credit history and consistent payment practices are more likely to be granted higher credit limits, while those with a less favorable track record may receive lower limits.
3. Discounts: Suppliers may offer incentives in the form of early payment discounts to motivate buyers to expedite their payments. These discounts can be advantageous for both parties. For instance, a supplier might provide a 2% discount if the buyer pays the invoice within 10 days, even if the standard terms are “Net 30.” This encourages prompt payment, benefitting the buyer through cost savings and the supplier through improved cash flow.
4. Credit Application: In many cases, buyers are required to submit credit applications to initiate or amend their credit relationships with suppliers. These applications serve to establish the buyer’s creditworthiness and can encompass various financial and business references, credit history, and other relevant information. The supplier reviews these applications to assess the risk associated with extending credit to the buyer.

It’s important to note that trade credit isn’t solely limited to payment terms but can also include other elements, such as return policies, delivery terms, and dispute resolution procedures, which are negotiated and agreed upon as part of the overall trade credit agreement. Trade credit agreements are designed to facilitate a seamless exchange of goods and services while minimizing financial strain on the buyer and offering suppliers a degree of financial security in the form of predictable payments.

II. Examples of Companies Utilizing Trade Credit

Trade credit plays a pivotal role in the operations of various companies. Here are a few examples:

1. Walmart: Walmart, one of the world’s largest retailers, maintains extensive trade credit relationships with a wide range of suppliers. These relationships enable Walmart to stock its shelves without depleting its cash reserves, ensuring a steady supply of products to meet customer demand.
2. General Electric (GE): GE has a vast network of suppliers for its industrial and technological products. It relies on trade credit to secure the components and materials it needs for manufacturing, thus keeping its production lines running smoothly.
3. Amazon: As an e-commerce giant, Amazon works with numerous suppliers to fulfill customer orders. Trade credit allows Amazon to manage its inventory effectively and offer a wide range of products to its customers without tying up substantial capital.
4. Coca-Cola: The beverage industry heavily depends on trade credit. Coca-Cola, for instance, relies on trade credit agreements to ensure a continuous supply of ingredients and packaging materials.

We have a more extensive guide on how does trade credit works here.

III. The Significance of Trade Credit

Trade credit is not just a financial transaction; it is a driving force behind global commerce and economic development. Here are detailed insights into its significance and the statistics that support its pivotal role in the business world:

1. Global Impact:
   • International Commerce Backbone: The International Chamber of Commerce (ICC) recognizes trade credit as the backbone of international commerce. It facilitates more than 90% of global trade transactions. This means that the vast majority of cross-border exchanges rely on credit arrangements between businesses. It enables companies of all sizes to engage in global supply chains, fostering international trade and economic interdependence.
   • Complexity and Diversity: Trade credit’s global impact is underscored by its adaptability across diverse industries, sectors, and geographies. It is a versatile tool that accommodates the varying needs and requirements of businesses engaged in international trade.
2. Contribution to Economic Growth:
   • Working Capital for Expansion: Trade credit is instrumental in providing businesses with the working capital required for their daily operations and expansion plans. By deferring payments, buyers can allocate their funds to investment, research, development, and scaling their operations, which, in turn, stimulates economic growth.
   • Job Creation: The ability to access trade credit empowers businesses to expand their operations, leading to job creation and economic development. As companies grow, they typically hire more employees to meet increased demand, thus contributing to job market growth.
3. Cash Flow Management:
   • Stabilizing Cash Flow: According to a survey conducted by the National Association of Credit Management, 90% of businesses utilize trade credit as a strategic tool to manage their cash flow effectively. This practice helps businesses navigate financial fluctuations and economic downturns. By deferring payments while still receiving necessary goods and services, businesses can maintain liquidity, ensuring they have the necessary funds on hand for essential expenses and investments.
   • Risk Mitigation: Trade credit can serve as a risk mitigation strategy, especially in volatile markets. It provides businesses with financial flexibility, helping them to adapt to unforeseen circumstances and maintain financial stability during uncertain economic periods.
4. SMEs and Trade Credit:
   • Lifeline for Small Businesses: Small and medium-sized enterprises (SMEs) are the backbone of many economies. Trade credit often acts as a lifeline for these businesses, enabling them to compete with larger corporations. The Small Business Administration (SBA) notes that approximately 30% of SMEs’ financing comes from trade credit arrangements. This financial support allows SMEs to access necessary resources and maintain competitiveness in their respective markets.
   • Leveling the Playing Field: Trade credit empowers SMEs by giving them the financial flexibility needed to enter into business agreements, establish relationships with suppliers, and expand their operations. Without the need for immediate capital, SMEs can more effectively compete with larger counterparts.