Trade Credit, What Is It?
Trade credit exists when one provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate the business if it is managed properly.
Trade credit is the largest use of capital for a majority of business to
business (B2B) sellers in the United States and is a critical source of capital
for a majority of all businesses. For example, Wal-Mart, the largest retailer in
the world, has used trade credit as a larger source of capital than bank
borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested
by shareholders. (Trade credit is the second largest source of capital for
Wal-Mart; retained earnings is the largest.)
There are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives.
Let's say you operate an ice cream stand under a franchise which agrees to
provide you with ice cream stock under the terms Net 60 with a ten percent
discount on payment within 30 days, and a 20 percent discount on payment within
10 days. This means that you have 60 days to pay the invoice in full. If you
sell a sufficient amount of ice cream at your markup within a week, then you can
dispatch a check for 80 percent of the invoice, and make an extra 20 percent on
the ice cream sold. However, if sales are slow, leading to a month of low cash
flow, then you may decide to pay 90 percent within 30 days or use the money
another 30 days and pay the full invoice amount within 60 days.
The ice cream distributor can do the same thing. Receiving trade credit from milk and sugar suppliers on terms of Net 30, 2 percent discount, if paid within ten days, means he is apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would he do this? First, remember he has a substantial markup on the ingredients and other costs of production of the ice cream he sells to you. There are many reasons and ways to manage trade credit terms for the benefit of a business. The ice cream distributor may be well capitalized either by steady profits or recent new investments and may be looking to expand his markets. In this case he is being aggressive in attempting to locate new customers or to help them get established. Having experienced a few customers going out of business from cash flow instabilities he has decided on financial terms to accomplish two things:
Allow startup ice cream parlors the ability to mismanage their investment in inventory for a while, while learning their markets without having a dramatic negative balance in their till or bank account, which could put them out of business. This is in effect, a short term business loan made to help expand the distributor's market and customer base.
By tracking who pays, and when, the distributor can see potential problems developing and take steps to reduce or increase the allowed amount of trade credit he extends to prospering or faltering businesses. This limits the exposure to losses from customers going bankrupt who would never pay for the ice cream delivered. It is better to have a $5,000 loss than a $30,000 loss.