What's Trade Credit?

Trade credit is a type of short-term financing extended by suppliers to buyers, allowing the buyer to purchase goods or services and pay at a later date, typically within 30, 60, or 90 days. It plays a key role in supporting cash flow, maintaining supply chain continuity, and enabling business growth. Trade credit is widely used in industries such as manufacturing, wholesale, and retail.

Unlike traditional loans, trade credit does not involve banks or financial institutions. It is a business-to-business (B2B) arrangement where the supplier delivers goods or services with the expectation of future payment.

This setup helps buyers acquire the resources they need without an immediate cash payment, while suppliers benefit by building customer loyalty, encouraging repeat purchases, and strengthening commercial relationships.

However, trade credit also introduces risk. If a buyer fails to pay on time or defaults, the supplier may face financial strain. Understanding and managing trade credit risk is essential to protecting the business.

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How Trade Credit Works

When a business extends trade credit, they are essentially giving the buyer a loan without formal interest charges—although sometimes suppliers might add a discount for early payment. The terms of the trade credit—how much is extended, when the payment is due, and what consequences exist for late payment—are agreed upon in advance. These terms are a critical part of managing trade credit risk, as they define how the transaction will be handled and the expectations for both parties.

For example:

• A supplier might offer a 30-day payment term on a shipment of goods, meaning the buyer must pay for the goods within 30 days.
• If the buyer pays on time, they maintain a good relationship with the supplier and can continue purchasing on credit.
• If the buyer fails to pay on time, they could face penalties or interest charges, or even lose the ability to purchase on credit in the future.

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What is Trade Credit Risk?

Trade credit risk is the possibility that a business (the buyer) will fail to repay its debt for the goods or services it has received. In other words, it's the risk that the supplier will not get paid as expected. This risk exists because the buyer may face cash flow issues, be unable to sell the goods they purchased, or even experience financial distress or bankruptcy.

For suppliers, managing trade credit risk is critical to ensure they don’t experience significant financial losses. While trade credit is often a tool for building customer relationships and boosting sales, it can also expose businesses to bad debt if customers don’t pay as agreed.

More on that later! (See Managing Risk)

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The Benefits of Trade Credit

For suppliers, trade credit can drive sales and build long-term relationships with customers. By offering credit, suppliers give buyers the flexibility to purchase more goods, which can increase the supplier’s revenue and market share. It also provides an opportunity to differentiate from competitors who may not offer credit terms.

For buyers, trade credit provides a way to manage cash flow. It allows them to purchase goods or services without immediate payment, enabling them to sell the products or use the services before payment is due. This flexibility is essential for many businesses, especially those that need time to convert inventory into sales.

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The Bottom Line

Trade credit is a vital financial tool that helps businesses grow and manage cash flow. However, it also comes with inherent risks. Understanding and managing trade credit risk is crucial for businesses offering credit to ensure they aren’t exposed to financial losses. By assessing the creditworthiness of customers, setting clear credit terms, and employing risk management strategies like credit insurance and regular monitoring, suppliers can confidently extend credit while minimizing the risk of bad debt.

Ultimately, trade credit is about fostering trust and building strong, long-term relationships between suppliers and buyers. With effective risk management, businesses can leverage trade credit to fuel growth, enhance customer loyalty, and remain financially secure.

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