# Understanding Trade Credit: Benefits, Risks, and Accounting Practices

> **Definition**
>
> Trade credit is a business-to-business financing arrangement that allows a buyer to purchase goods or services and defer payment to a later date, typically without incurring interest charges.

## What Is Trade Credit?

Trade credit is a [business-to-business (B2B)](https://www.investopedia.com/terms/b/btob.asp) agreement in which a customer can purchase goods without paying cash upfront and pay the supplier at a later, scheduled date. Usually, businesses that operate with trade credits will give buyers 30, 60, or 90 days to pay, with the transaction recorded through an invoice.

Trade credit can be thought of as a type of 0% [financing](https://www.investopedia.com/terms/f/financing.asp) for suppliers and as a way to increase the lending company's [assets](https://www.investopedia.com/terms/a/asset.asp). However, this type of credit agreement can create accounting complexities and increase collection risks.

### Key Takeaways

*   Trade credit allows businesses to purchase goods or services and defer payment without incurring interest.
*   It improves a buyer's cash flow by allowing sales revenue to cover future payments for goods received.
*   Suppliers may offer discounts on trade credit payments to encourage early settlement from buyers.
*   Default risks exist for suppliers, with potential impacts on their financial health if buyers fail to pay.
*   Trade credit is a valuable option for buyers with limited financing alternatives, benefiting short-term growth.

![Trade Credit](https://www.investopedia.com/thmb/fL8Dqbt8Dw5L-9zPog0FgtiUhWU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/trade-credit.asp_final-c2e262c45bb943a682814cf365b1c1c5.png)

*— NoNo Flores / Investopedia*

## How Trade Credit Works for Businesses

Trade credit is an advantage for a buyer. In some cases, certain buyers may be able to negotiate longer trade credit repayment terms, which provides an even greater advantage. Often, sellers will have specific criteria for qualifying for trade credit.

A B2B trade credit can help a business to obtain, manufacture, and sell goods before ever having to pay for them. This allows businesses to receive a [revenue](https://www.investopedia.com/terms/r/revenue.asp) stream that can retroactively cover the [cost of goods sold](https://www.investopedia.com/terms/c/cogs.asp).

[Walmart](https://www.investopedia.com/articles/markets/092115/these-are-benefits-investing-walmart.asp) is one of the biggest utilizers of trade credit, seeking to pay retroactively for [inventory](https://www.investopedia.com/terms/i/inventory.asp) sold in its stores. International business deals also involve trade credit terms. In general, if trade credit is offered to a buyer, it typically provides an advantage for a company's [cash flow](https://www.investopedia.com/terms/c/cashflow.asp).

The lending company sets the credit period, which is agreed upon by both the creditor and the debtor. Trade credit can also be an essential way for businesses to finance short-term growth. Trade credit, which is interest-free, is often used to boost sales.

Suppliers often offer discounts to encourage early payments because trade credit can put them at a disadvantage. For example, a supplier might offer a 2% discount if a customer pays within 10 days on a 30-day credit. This discount would be referred to as 2%/10 net 30 or simply just 2/10 net 30.

## Accounting for Trade Credit: Key Considerations

Trade credits are accounted for by both sellers and buyers. Accounting with trade credits can differ based on whether a company uses [cash accounting](https://www.investopedia.com/terms/c/cashaccounting.asp) or [accrual accounting](https://www.investopedia.com/terms/a/accrualaccounting.asp). Accrual accounting is required for all public companies. With accrual accounting, a company must recognize revenues and expenses at the time they are transacted.

Trade credit invoicing can make accrual accounting more complex. If a public company offers trade credits, it must book the revenue and expenses associated with the sale at the time of the transaction. When trade credit invoicing is involved, companies do not immediately receive cash assets to cover expenses. Therefore, companies must account for the assets as [accounts receivable](https://www.investopedia.com/terms/a/accountsreceivable.asp) on their balance sheet.

Default is a risk with trade credit. Companies offering trade credits also usually offer discounts, which means they can receive less than the accounts receivable balance. Both defaults and discounts can require accounts receivable [write-offs](https://www.investopedia.com/terms/w/write-off.asp) from defaults or write-downs from discounts. Companies must report these as liabilities.

Alternatively, trade credit benefits the purchasing businesses. A company can obtain assets, but would not need to credit cash or recognize any expenses immediately. In this way, trade credit can act like a 0% loan on the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp).

The company's assets increase, but cash does not need to be paid until sometime in the future, and no interest is charged during the repayment period. A company only needs to recognize the expense when cash is paid, using the cash method, or when revenue is received, using the accrual method. Overall, these activities greatly free up cash flow for the buyer.

## Current Trends and Innovations in Trade Credit

Trade credit is most rewarding for businesses that do not have a lot of financing options. In financial technology, new types of point-of-sale financing options are being provided for companies to utilize in place of trade credits. Many of these [fintech](https://www.investopedia.com/terms/f/fintech.asp) firms partner with sellers at the point of sale to provide 0% or low-interest financing on purchases. These partnerships help to alleviate trade credit risks for sellers while also supporting growth for buyers.

Trade credit has led to new seller financing solutions like [accounts receivable financing](https://www.investopedia.com/terms/a/accountsreceivablefinancing.asp). Accounts receivable financing, also known as invoice financing or factoring, is a type of financing that provides businesses with capital in relation to their trade credit: accounts receivable balances.

From an international standpoint, trade credit is encouraged. The World Trade Organization (WTO) reports that 80% to 90% of world trade is in some way reliant on trade finance. Trade finance insurance is also a part of many trade finance discussions globally, with many new innovations. LiquidX, for example, now offers an electronic marketplace focused on [trade credit insurance](https://www.investopedia.com/trade-credit-insurance-5190219) for global participants.

Research conducted by the U.S. Federal Reserve Banks also highlights some important insights. The 2022 Small Business Credit Survey reveals that trade credit finance is the third most popular financing tool used by small businesses, with 9% of companies reporting its use.

## Related Concepts and Other Considerations

Trade credit has a significant impact on the financing of businesses and is therefore linked to other financing terms and concepts. Other important terms that affect business financing are credit rating, trade line, and buyer’s credit.

A [credit rating](https://www.investopedia.com/terms/c/creditrating.asp) is an overall assessment of the creditworthiness of a borrower, whether a business or individual, based on financial history that includes debt repayment timeliness and other factors. Without a good credit rating, trade credit may not be offered to a business.

If businesses do not pay trade credit balances according to agreed terms, then penalties in the form of fees and interest are usually incurred. Sellers can also report [delinquencies](https://www.investopedia.com/terms/d/delinquent.asp) on trade credit, which may affect a buyer’s credit rating. Delinquencies affecting a buyer’s credit rating can also affect their ability to obtain other types of financing.

> **Important**
>
> Trade credit is usually only available for businesses with an established credit history. New businesses without a credit history may have to look at other means of financing.

A [trade line](https://www.investopedia.com/terms/t/trade-line.asp) is a business credit account record provided to a business credit reporting agency. Rating agencies like [Standard & Poor's](https://www.investopedia.com/terms/s/sp.asp), [Moody's](https://www.investopedia.com/terms/m/moodys.asp), or [Fitch](https://www.investopedia.com/terms/f/fitch-ratings.asp) track trade lines for large and publicly traded companies.

[Buyer's credit](https://www.investopedia.com/terms/b/buyers-credit.asp) is related to international trade and is essentially a loan given to specifically finance the purchase of capital goods and services. Buyer's credit involves different agencies across borders and typically has a minimum loan amount of several million dollars.

## Advantages and Disadvantages of Trade Credit

### Buyers

The advantages of trade credit for buyers include simple and easy access to financing. It is also an affordable type of financing that comes at no extra cost compared to other means of financing, such as a loan from a bank.

Because payment is not due until later, trade credits improve the cash flow of businesses; they can sell the goods they acquired without having to pay for those goods until a later date. Trade credits also improve your business profile as well as your relationship with your vendors.

The disadvantages of trade credit include high costs if payments are not made on time. Costs usually appear in the form of late-payment penalty charges or interest charges on the outstanding debt. If payments are not made, this can also negatively impact the credit profile of your business as well as the relationship with your supplier.

### Sellers

The advantages of trade credits for sellers include building a strong relationship with your clients, encouraging customer loyalty and, therefore, repeat business. Trade credits can also lead to higher sales volumes, as buyers are likely to purchase more when there is no cost associated with the financing.

Sellers have a few more disadvantages than buyers when it comes to trade credits. These include delayed revenue. If a business is flush with cash, that’s not a problem. Tight budgets can make delayed revenue a problem for [operating costs](https://www.investopedia.com/terms/o/operating-cost.asp).

Trade credits also come with bad debts, as some buyers will inevitably not be able to pay. This means a business takes on risks when extending financing. Bad debts can be written off, but having a customer not pay can always be detrimental to a business.

Pros

*   Cost-effective means of financing for buyers
    
*   Improves cash flow for buyers
    
*   Encourages higher sales volumes for sellers
    
*   Leads to strong relationships and customer loyalty for sellers
    

Cons

*   High cost for buyers if payments are not made on time
    
*   Late payments or bad debts can negatively impact a buyer’s credit profile and relationship with suppliers
    
*   Sellers run the risk of buyers not paying their debts
    
*   Delayed payments can be a strain on the balance sheet for sellers
    

## What Are the Most Common Terms for Using Trade Credit?

The most common terms for using trade credit require a buyer to make payment within seven, 30, 60, 90, or 120 days. A percentage discount is applied if payment is made before the date agreed to in the terms.

## What Type of Credit Is Trade Credit?

Trade credit is commercial financing whereby a business is able to buy goods without having to pay until later. Commercial financing in relation to a trade credit comes at a 0% borrowing cost.

## What Are the Types of Trade Credit?

Trade credits can come in the form of open accounts, promissory notes, or bills payable.

*   An open account is an informal agreement where the seller sends the goods and an invoice to the buyer.
*   A promissory note is a formal agreement where the buyer agrees to the terms, including the payment date, and signs and returns the document to the seller.
*   Bills payable refer to financial instruments drawn by the seller and accepted by the buyer with an agreement of payment on the expiry date.

## Is Trade Credit Expensive?

In its purest form, trade credit is not expensive to the buyer, as there is no associated cost. Trade credit is an interest-free loan.

However, trade credit can be expensive if payment is not made by the agreed-upon date, whereby a borrower can incur high costs, either through late fees or an interest rate charged by the seller on the outstanding amount.

## The Bottom Line

Trade credit is a business-to-business, interest-free loan that allows buyers to defer payments while still acquiring the necessary inventory or equipment. It benefits suppliers by providing future cash flows and increasing their assets, but it also adds the risk of the buyer defaulting or making late payments. Trade credit plays an important role in enhancing buyer-supplier relationships and promoting business growth, but it comes with the need for businesses to manage these transactions carefully, given the financial risks involved.

Buyers using trade credit should be aware that they may be penalized by the supplier through increased interest rates or by being reported to credit bureaus, which can negatively impact their credit ratings.  

Businesses considering trade credit can explore emerging technologies and trends, such as factoring or partnering with a fintech firm that offers point-of-sale credit solutions.

> **Article Sources**
>
> 1.  Congressional Research Service Reports. “[Cash Versus Accrual Basis of Accounting: An Introduction](https://crsreports.congress.gov/product/pdf/R/R43811),” Pages 3–4 (Pages 6–7 of PDF).
>     
> 2.  World Trade Organization. “[Trade Finance](https://www.wto.org/english/thewto_e/coher_e/tr_finance_e.htm).”
>     
> 3.  LiquidX. “[How Digitization Is Transforming Trade Credit Insurance](https://www.liquidx.com/blog/how-digitization-is-transforming-trade-credit-insurance/).”
>     
> 4.  U.S. Federal Reserve Banks, via Fed Small Business. “[Small Business Credit Survey: 2022 Report on Employer Firms](https://www.fedsmallbusiness.org/medialibrary/FedSmallBusiness/files/2021/2022-sbcs-employer-firms-report),” Page 19 (Page 25 of PDF).