Types of Trade Credit
There are several types of trade credit:
| Open account |
an informal agreement.
After the goods are shipped, the seller sends the invoice to the buyer. Mostly, the number of goods, the total amount, and the due date are indicated in this invoice.
From this moment, the seller recognizes this amount as accounts receivable and the buyer as accounts payable. |
| Promissory note |
The formal agreement signed by a buyer.
It may have a longer maturity than an open account. Such a type of trade credit may bear some interest if payment is made after the due date. |
| Trade acceptance (commercial draft) |
A formal document drawn by a seller and accepted by a buyer.
Before goods are shipped, the seller draws a draft. In this draft, the amount and the due date are indicated. Only after accepting it, the seller will ship the goods. |
Trade Credit Accounting
Accounting the trade credit is different for buyers and for sellers.
During such an agreement, sellers do not immediately receive cash assets, but actually, they have sold the product or service. So in the balance sheet, it appears as Accounts Receivable on a part of assets. Actually, this is more-less risky assets, but this is the assets that turn into cash much easier than any other assets from the balance sheet.
Alternatively, trade credit is a useful option for businesses on the buying side. As this is a credit agreement, and we can call it short-time credit from the supplier, this is qualified as Accounts Payable and arise Liability in the balance sheet.
Normally, the company has both of them, for some people they are creditors and for others they are debtors. So, the relation between these two parts is very meaningful. It is better for the company’s financial stability that the day agreed to debtors (from accounts payable) be less than the day agreed with creditors (accounts payable).
Advantages and disadvantages of Trade Credit
The main advantage of Trade credit is that it is very easy to arrange it, not as many procedures as in a bank, without any collateral demands. Moreover, many businesses use such type of relationship in an everyday business working model.
However, using trade credit involves the following disadvantages and the main one is the high cost.
Although it has no interest rate, in case of cash payment immediately or early than date, many suppliers use discounts. Also, such finance is riskier, a supplier has no guarantee of payment and it is very much depended on relationship history, the creditworthiness of the buyer, etc. In case of late payment, the supplier can use tools like fine or penalties, which are quite high and increase the cost of goods.
Trade credit terms and dates can be different for businesses and industries, for example in businesses such as shopping, the dates will be shorter than businesses like industrial manufacturing.
Trade credit has a big impact on the financing of businesses. The World Trade Organization reports that 80% to 90% of world trade is connected to trade finance. This plays a big role in supporting and correctly developing business.
