Trade Credit is a process of ordering and receiving goods or services for business purposes by not making immediate cash payment to the suppliers. It is an inter-firm trade credit among buyers and sellers, wherein goods are shipped or services are offered in advance, before the payment is made.
What is Trade Credit?
Trade Credit is a business-to-business agreement in which credit limit is offered to the borrower (buyer) by supplier who let the borrower buy now and pay later. Trade Credit is used whenever an entrepreneur is receiving equipment, machinery, material and other business related products and not paying back cash instantly but paying later on or before the scheduled date. The credit limit depends on the business requirements, current assets and liabilities, repayment capacity and creditworthiness of the buyer.
Features of Trade Credit
• Internal agreement between buyer and seller
• Instant and short-term source of financing
• Acts as a working capital loan
• Increases cash flow and reduces capital requirements
• No interest rate to be paid, if payment done within discount period
• Funding is based on company’s establishment, and good financial and repayment history
Generally, buyers are granted time of 30, 60 or 90 days to repay the borrowed amount in the form of an invoice by businesses engaged in trade credit. For some trades, credit repayment time may extend to up to 180 days or longer. In this way, the buyer can avail, manufacture and sell products before even have paid for them. This leads to the revenue generation from the sold products which further can be used to pay against the sanctioned credit limit.
For example: If a buyer have agreed credit trade limit payment to be made in 40 days to suppliers and trade credit term of 30 days with customers, the net benefit will be 10 days.
Trade credit is a form of 0% financing in which no or little interest rate is charged by businesses or paid by buyer against the goods and services purchased. This means there is no repayment charge for this financial instrument. It is a type of agreement for certain number of days for sanctioned credit limit by company allowing credit trade and is agreed by both the businesses involved in the trading.
For start-ups, getting trade credit could be a difficult task, as companies offering trade credit chooses established companies with sound financial background. However, start-ups or MSMEs which are recently established can approach various suppliers offering trade credit facility.
Trade Credit Formula
Amount to pay = Total Amount x (1-discount)
Cash Discount Policy
Trade Credit is signified by three numbers, wherein first two indicate discount percentage and discount period and last number denotes the final due date. For Example: 3/10 Net 30.
What does 3/10 Net 30 mean?
3/10 Net 30 is the trade credit offered and if 3/10 is displayed, it means that there is 3% of discount is offered to the borrower, if the balance is paid within 10 days from the date of receipt. Or else the borrower amount is due in full within 30 days from the date of issuance.
For Example: If an individual purchases Rs. 10 lakh from Company A on the terms 3/10 net 30 and pays within 10 days, the borrower only needs to pay (Rs. 1000000 – Rs. 30000 = Rs. 970000). On the other hand, if the customer pays after 10 days, he must pay the full amount of Rs. 10 lakh.
Banks offering Trade Credit
Recent Rules from RBI
• Time period permitted for the trade credit to imports should be in conformity with the general transaction period and operating cycle
• For availing trade credit, time period of trade credit should always be linked with the trade transaction operating cycle
Dependable, trustworthy and reliable suppliers are the key factors to build and expand business, as getting a trade limit from them can be benefited in various aspects. Paying the borrower amount within 10 days (approx.) not only reduces the burden of the buyer but also makes him/her eligible to avail discount over the total amount.
If not able to repay in 10 days, still the buyer is in double profit, as he/she is getting trade limit at 0% interest rate and secondly, buyer is making money by selling goods and services which are manufactured or produced from the money gained from Trade Credit limit.