Trade Credit

How Does Trade Credit Work?

Trade credit follows a simple process where the supplier provides goods or services with the understanding that payment will be made after a specified period. Here's how it works:

1. Set Terms: The supplier and buyer agree on the credit period, payment terms, and any penalties for late payment.
2. Delivery: The supplier delivers the goods or services as agreed.
3. Invoice: An invoice is issued detailing the amount due and the payment deadline.
4. Payment: The buyer settles the payment within the agreed timeframe.

Types of Trade Credit

Trade credit can be divided into several types depending on the payment terms. The main types of trade credit include:

• Open Account Trade Credit: The supplier provides goods or services and sends an invoice with a due date. The buyer is expected to make the payment within the agreed period, typically between 30 to 90 days.
• Promissory Notes: The buyer issues a written commitment to pay the supplier at a specified future date. This document acts as a legal promise to settle the payment.
• Bill of Exchange: A written order from the supplier instructing the buyer to pay a fixed amount on a specified date. This document legally obligates the buyer to make the payment.

Advantages of Trade Credit

Trade credit offers distinct benefits to both buyers and sellers. Some of them are:

For Buyers:

• Boosts Cash Flow: Buyers can obtain goods or services and generate income before the payment is due, improving liquidity.
• Promotes Business Expansion: Deferred payments free up funds that can be used for scaling operations or other investments.
• No Collateral Required: Since trade credit is usually unsecured, buyers are not required to pledge assets.
• Strengthens Supplier Ties: Prompt payments enhance trust and can lead to better terms in future deals.

For Sellers:

• Drives More Sales: Offering trade credit attracts more buyers and increases overall sales.
• Competitive Edge: Flexible payment options make the seller’s offer more appealing.
• Encourages Repeat Business: Trade credit builds customer trust and increases the chances of future transactions.
• Additional Revenue: Sellers can earn extra income through interest or penalties on late payments.

How to Perform Credit Analysis?

Credit analysis helps businesses assess a customer's ability and willingness to meet payment obligations before granting trade credit. Here's how to evaluate creditworthiness:

1. Review Financial Statements: Request the customer’s financial statements and analyze key financial ratios to assess liquidity, profitability, and overall financial health.
2. Check Credit Reports: Obtain credit reports from agencies to review the customer’s payment history with other businesses and identify any red flags.
3. Consult Banks: Banks often provide insights into a company’s financial stability and creditworthiness.
4. Analyze Payment History: A customer’s track record with your business is a strong indicator of their reliability in meeting future payments.
5. Evaluate the 5 C’s of Credit:
• Character: Assess the customer’s reputation and willingness to fulfil payment obligations.
• Capacity: Evaluate the customer’s ability to pay using operating cash flow.
• Capital: Review the customer’s financial reserves and net worth.
• Collateral: Identify any assets the customer can pledge in case of default.
• Conditions: Consider the impact of market trends and economic conditions on the customer’s ability to pay.

How to Manage Trade Credit Effectively?

Managing trade credit properly helps both buyers and sellers maintain steady cash flow and strengthen business relationships. Here’s how each party can handle trade credit more effectively:

For Sellers:

• Define Payment Terms Clearly: Set clear expectations on payment deadlines, late fees, and any discounts for early payments.
• Track Customer Payments: Monitor how customers handle payments to spot issues early and manage overdue accounts quickly.
• Evaluate Creditworthiness: Regularly assess customers’ financial health and adjust credit limits based on their payment history.
• Improve Terms for Reliable Customers: Strengthen relationships and boost sales by offering better terms to consistent payers.

For Buyers:

• Understand Payment Terms: Carefully review supplier terms to avoid penalties and maintain a positive relationship.
• Build a Strong Payment Record: Paying on time consistently improves credibility and future credit options.
• Monitor Outstanding Balances: Keep track of due payments to prevent cash flow problems and ensure timely settlements.
• Use Good Payment History: Leverage a positive payment record to secure better terms and higher credit limits.