Trade Credit

What It Means

Trade credit is a contractual agreement in which one business receives goods or services from another business without having to pay immediately for those goods and services. The business that has received the goods or services will pay the lending business at a later date, which is specified in the agreement. For example, a hot dog business that gets trade credit from a supplier receives hot dogs from that supplier at the start of the month and does not have to pay for the inventory for two months. Such an agreement is called a “Net 60 agreement,” which means that the supplier would expect the invoice (the bill) for the hot dogs to be paid in full after 60 days.

In most Net 60 agreements, a discount is offered if the bill is paid early. In this case the owner of the hot dog stand might receive a 20 percent discount for paying the bill within 10 days and a 10 percent discount for paying the bill within 30 days. For example, if the owner of the hot dog stand was billed $1,000 on a Net 60 agreement, he would have to pay only $800 if he paid the invoice within 10 days of receiving the shipment. He would have to pay $900 if he paid the invoice within 30 days of receiving the shipment. A Net 30 agreement is another common arrangement, according to which full payment is due 30 days after receiving the goods or services. Most Net 30 arrangements offer a 2 percent discount if payment is received within 10 days.

When Did It Begin?

In a sense, trade credit has existed since the beginning of commerce because people have always had to borrow from one another in order to survive. When a person provided goods in exchange for other goods that would be received at a later date, that person was extending a form of trade credit. A person might trade wood to a neighbor, for example, in exchange for a crop that would be harvested later in the year.

Trade credit resembling the exchanges that take place today first began in the nineteenth century at the end of the Industrial Revolution in Europe. At this time, manufacturers often needed large amounts of raw materials to run their machines before they had the money to pay for those materials. For example, the coal that was required to run textile mills (which produced such items as clothing and carpeting) was often purchased on credit and paid for with the proceeds from the sale of the textiles.

More Detailed Information

Trade credit offers the company receiving the goods or services a significant benefit: the invoice for the goods or services need not be paid until after a profit has been made. For example, assume that the hot dog vendor receives 1,000 hot dogs on the first of the month for $1,000. The vendor sells the hot dogs at a markup, or higher price, to his customers. He charges $3 for a hot dog. After a good weekend at the start of the month, the vendor sells 334 hot dogs for a total cash intake of $1,002. He is able to pay his invoice within 10 days, and, because he is paying early, he will owe only $800. So, he has already made a profit of $202, and he still has 666 more hot dogs to sell. In another scenario, the weather is bad in the early part of the month, and the vendor sells very few hot dogs. But he need not worry about paying his bill immediately because he has 60 days to earn the $1,000 needed to pay the invoice.

Although the terms of the trade credit agreement seem to favor the hot dog vendor in this case, it is possible to look at the agreement in another less favorable way. The trade credit agreement could be regarded as a high-interest, short-term loan. According to the terms of a Net 60 agreement, the hot dog vendor has just 10 days to pay an $800 bill. If he cannot make that $800 payment, then he could pay as much as 20 percent interest on that loan.

Regardless of how one views this type of financial relationship, both parties can benefit from trade credit. The receiving company, which is often smaller than the lending company, can maintain a steady level of inventory and thus have product available to its customers. Trade credit also gives the receiving company an opportunity to manage its inventory and to understand the spending habits of its customers. By keeping accurate records the receiving company can anticipate how many supplies it will need and order the appropriate amount so that it can pay its bill within 10 days and receive its discount.

The lending company can also use trade credit to help increase its profits. Suppliers are always looking for businesses that need their goods. By offering favorable terms of trade credit, a supplier can find new businesses to purchase its supplies. The supplier may offer a start-up company trade credit if the supplier thinks that the start-up company has a good chance to become a successful business. If the start-up company flourishes it will require more inventory, and the supplier’s profits will therefore increase along with the start-up’s. A supplier may use favorable terms of trade credit to lure an established business away from its current supplier. Suppliers monitor the paying habits of all businesses that receive their supplies. These suppliers often reward their best customers with improved terms of trade credit.

Recent Trends

The risks associated with extending trade credit vary, depending largely on the economy in the part of the world to which a company is extending trade credit. Many countries in Latin America, for example, are reducing their national debt, which in turn makes the business environment in these countries more stable. This stability has made it possible for businesses to receive more trade credit because they are not as likely to default on, or fail to pay, their bills. Latin America has also experienced increased political stability in the last decade, and this political stability indicates that recent economic growth might be long lasting.

Economies in other parts of the world are growing, too, but a lack of political stability has increased the risk associated with extending trade credit to businesses in these countries. For example, the Commonwealth of Independent States (CIS), a coalition of 11 former Soviet Republics including Russia, is thriving economically, but the threat of political upheaval looms throughout the region. Therefore, high risk is associated with lending to businesses in the CIS. The same is true in Central Europe, Turkey, the Near and Middle East, and North Africa.