Trade credit

This article covers trade credit: what it is, why it exists, and how it works.

Believe it or not, trade credit is 3x as important for small businesses as financial credit, according to the smart guys at Yale .

What exactly is trade credit?

Trade credit is simply the idea of "buy now, pay later" as applied to business transactions. From the point of view of the buyer, it's a great benefit, for reasons we'll get into below. From the point of view of the seller, it's not necessarily great, but it does have its good side as well.

Why do businesses offer trade credit terms?

Trade credit is an industry standard practice in many markets. Therefore, in certain industries, it's expected by both buyers and sellers that the seller will wait some amount of time to collect payment.

However, as formal and legalistic as the process of trade credit can sound, it is ultimately a game of raw power. Sellers generally hate having to extend trade credit, because it ties up the seller's cash flow. Buyers generally love being able to get trade credit, because of the advantage of float. Therefore, a seller will generally only extend credit terms if the game of raw power forces it to.

How do invoices work? What are NET-30 terms?

If we try to explain it as though it were a machine, it would seem way more complicated than it really is. An example will make this clear, below.

An example of Trade Credit

Byer Corp. wants to purchase $10,000 worth of widgets. Byer plans to turn around and sell those widgets (or use them to make something else that they'll eventually sell) for more money. But, because cash is always scarce, Byer doesn't want to hand over the $10,000 purchase price up front. (Perhaps they want to use the $10,000 for some other purpose in the interim.)

Larry the Loser LLC is competing for the business, and is willing to sell the widgets at the offered price. However, Larry demands cash up front.

Sellers Systems Inc. is competing for the business, and is able to sell the needed widgets for $10,000. Sellers, however, is willing to wait 30 days after shipping the widgets to collect the money.

Byer Corp. looks at the two quotes, and chooses Sellers Systems Inc., because although both vendors quoted the same price, Sellers Systems is willing to wait 30 days for payment. Both Byer and Sellers turn out to be winners here: Byer because they get a free "loan" for 30 days, and Sellers because they win the business without having to drop their price.

Industry jargon used in our example

  • Byer Corp. is the "buyer," but also the "borrower" or "debtor" until they pay off the $10,000.
  • Sellers Systems Inc. is the "seller" or "vendor," but they are also the "creditor," or rarely, we might say "lender."
  • Sellers Systems Inc. will ship the widgets, and send a bill known as an "invoice" to Byer corp. The Invoice will describe the sale and what amounts are now owed to Sellers by Byer.
  • The Invoice will describe the "terms" of the sale. When the terms say cash on delivery (COD) or cash in advance (CIA), we think of them as terms, but not really "credit terms," because the seller doesn't wait to collect payment.
  • When the terms of an invoice allow for some delay in payment, we consider them to be "credit terms." Commonly, these are stated as "NET-X" terms, where X is a number of days of delay permitted. The most common form of this is "NET-30," but in other industries it varies; for example, fresh produce is usually sold on "NET-10" terms.
  • (While we capitalize "NET" here, it's not an acronym, and NET-30 is commonly also written as "NET 30," "Net 30", or "Net 30 days.")
  • Finally, the "float" is the name for the buyer's privilege of keeping the purchase money until the due date (that is, of keeping the $10,000 for 30 days). When interest rates are high, that can generate interest, but the interest earned is usually of little importance. Float is mostly important so a buyer doesn't need to "tie up" as much precious cash with inventory.

Restating the example using the industry jargon

"Byer Corp. wanted trade credit terms for a $10,000 widget purchase order. Larry the Loser LLC offered COD terms, but Sellers Systems Inc. offered NET-30 terms at the same price. Therefore, Byer chose Sellers to do the deal because of the advantage of 30 days' float."

Congratulations, you now speak Accounts Receivable-ese (basic level) ;)

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