Trade credit is one of the important sources of short term financing options employed by firms. Trade credit may be defined as an arrangement to buy goods and/or services on account, i.e. without making immediate cash or cheque payments. This debt is usually recorded as “accounts payable” and is considered to be the single most important short term credit option for firms. Other short term financing options include:
• Commercial bank loans
• Commercial Paper (a promissory note)
• Secured loans
Trade credit is considered to be an important tool to finance business growth. When a business’ suppliers allow for trade credit, they allow firms to buy from them in present and pay in future. Such arrangement enables firms to take orders, make deliveries and then pay - effectively putting less pressure on cash flows to make payments on immediate purchases. Consequently, trade credit (if managed properly) helps reduce the capital required to operate a business.
When firms enter into a trade credit arrangement with their suppliers, a certain “credit term” is usually set. Cash / cheque payments made within this term (say, 15 days from the date of purchase) may qualify for a certain discount. However, if payments are not made within this term, all receivables are required to be settled within a stipulated time period (say 30 days from the date of purchase). The cost of NOT availing the discount is the cost of credit.
The credit term can differ for different types of businesses. Businesses that receive payments on delivery (an online shopping site, for example) may have a shorter credit term than a steel manufacturing unit where projects are of a longer duration, and payments may be received periodically on completion of certain pre-decided milestones.