TRADE CREDIT

Trade credit refers to the credit that one business extends to another in the course of doing business with each other. Trade credit may be extended by a purchasing firm to its supplier, or vice versa. If prepayment is made, then the purchaser is extending trade credit to the seller. Where the seller allows a certain time period for payment to be made, then the seller is extending trade credit to the buyer.

Trade credit may either be long term or short term. Examples of long term trade credit may be found in the automotive and petroleum industries, where it is common practice for manufacturers to extend long-term, low interest loans to their dealers. Trade credit, however, is most commonly short term, anywhere from 30 to 120 days, and is typically extended by a seller to a buyer.

A seller typically extends trade credit to a buyer by offering the buyer a specified time to pay for the goods that were purchased. The trade credit may be offered on net terms, which means that no interest will be charged if payment is made within the specified period, usually 30, 60, 90, or 120 days. A two-part offer of trade credit adds a discount period during which the purchaser may take a discount if payment is made within an even shorter period. For example, a "2/10 Net 30" offer means that the buyer has the option of taking a 2 percent discount if payment is made within ten days. Otherwise, full payment is expected within 30 days.

Two-part trade credit offers have an implicit interest charge built in. That is, if the purchaser chooses the "Net 30" option over the "2/10" option and fails to take the trade discount offered, then the purchaser is in effect paying an interest charge on the 30 days of credit that has been extended. When annualized, the interest rate on most trade credit far exceeds that offered by banks and other financial institutions. Consequently, some theorists hold that two-part trade credit offers provide sellers with information about the creditworthiness of their customers. It is argued that creditworthy customers would always take the trade discount, because they could find third-party financing at better rates than are offered by the two-part trade credit offer.

The actual credit terms of trade credit offers appear to be standardized within industries, although they may vary from industry to industry. They tend to remain constant and not be affected by supply and demand. The extending of trade credit can serve a business firm's informational and financial needs. In addition to providing sellers with information on the creditworthiness of their customers, trade credit offers can serve to bond relationships between buyers and sellers. Sellers who offer trade credit generally have a financial interest in maintaining a continuing relationship with their buyers. The extending of trade credit also gives the purchaser time to verify the quality of the goods purchased and evaluate the seller's performance.

Financially, the handling of trade credit offers and payments are part of a business firm's accounts receivable and accounts payable decisions. Financial decisions about extending two-part trade credit offers take into account the trade-off between offering a discount and receiving less money on the one hand, and receiving payment sooner and improving cash flow on the other. In terms of accounts payable, it is expected that all creditworthy firms would take advantage of trade discounts whenever possible. If no trade discount is offered, then simply being able to withhold payment for 30 to 120 days without paying interest improves the purchaser's cost of funds and provides greater control over cash flow.