What is Trade Credit? Types, Advantages, and Real-Life Examples

If your business runs its operations internationally, getting familiar with trade credits can help. Offering trade credit can open doors to stronger relationships, increased sales, and business growth. And for your customers, trade credit means more working capital and supply access.

Interest-free credit periods can build trust. But the other side of the coin shows capital strain, missed payments, and defaults. If you’re considering lending out trade credits to your customers, it’s important to understand the ins and outs first.

In this article, we’ll take you through what trade credit is, how it works, how it can help and hurt, and how to implement trade credits while avoiding the risks. Let’s get started.

• Trade credit is a short-term financing arrangement. Suppliers allow buyers to purchase goods or services and pay later, usually within 30–90 days.

• Trade credit has benefits for many small businesses, such as an increase in working capital, growth, and strengthening supplier-buyer relationships. 

• Suppliers can similarly benefit from trade credits by increasing their sales and fostering business relations.

• Suppliers carry many risks when providing trade credit. It is advised to follow best practices for mitigating them, including monitoring accounts, proper buyer evaluations, and setting credit limits.

Trade credit is a short-term arrangement between a supplier and a buyer. Instead of paying immediately, the buyer records the purchase as an entry in their ledger and pays within an agreed credit period (for example, 30 to 90 days).

What is trade credit? It is a commercial agreement that lets the buyer purchase goods or services from the supplier. The transaction is recorded using an invoice, and the payment for this transaction is performed at a later date. This time gap between the purchase and the payment is known as a credit period or a credit term, which can extend up to 30, 60, or even 90 days. For example, Net 30 is a payment term that asks the buyer to pay the invoice amount within 30 days.

Trade credit requires no additional interest and is a common financing option for smaller, scaling businesses.

Example: A scaling electronics manufacturer can use trade credit to expand its operations on a global scale and make repayments before the credit period finishes. Or, a textile exporter can ship its garments overseas. Selling the goods under the payment deadline allows the exporter to repay the money, avoid upfront payment, and secure a place in the international textile market.

Suppliers offer different kinds of trade credit. Common types include the open account, promissory note, bills of exchange, installment credit, consignments, and revolving credit.

Let’s take a look at how they’re defined:

Open accounts

Open accounts are informal trade credit agreements. The process works as usual, with the supplier selling the goods along with an invoice, and the buyer making the repayment within a pre-decided time period.

Promissory notes

Promissory notes are used for more formal agreements. Buyers provide such promissory notes to the seller, and make the repayment within the credit period. These trade credits can include an interest payment.

Bills of exchange

Bills of exchange introduce a legal binding element into the trade credit agreement, with the same basic process – the buyer accepts the bill of exchange, agreeing to pay the amount by a specified date.

Installment credit

With installment credits, buyers make the repayment in fixed and agreed-upon installments over time. Such trade credits have long credit periods, and can involve added interest charges, too.

Consignments

Here, the supplier sends the goods to the buyer, but ownership remains with the seller until the goods are sold. The buyer pays only after selling the goods.

Revolving credit

This credit type lets the buyer borrow up to a set limit, making the repayments gradually. Once repayment is made, the credit becomes available again for future use, making it a “revolving” type of trade credit.

The trade credit process starts with a purchase order, followed by the supplier delivering goods or services. The supplier then issues an invoice which states the due payment and its credit period. The buyer utilizes the supplies for their business operations, and completes the payment within the credit period.

For business transactions, the trade credit process follows a simple flow:

1. The buyer, often a smaller business, contacts the supplier to purchase goods or services, requesting deferred payment.
2. The buyer is evaluated for approval – at this stage, the supplier assesses the buyer’s credit history, business operations, and other factors.
3. The supplier then provides the goods or services, along with an invoice. This invoice details the amount of payment that is due, and the credit period, which is usually between 30 and 90 days.
4. The buyer can utilize the goods and services for their business operations.
5. Once the invoice matures and the credit period ends, the buyer completes the payment, free of interest.

This cycle is a practical tool for businesses seeking financing options.

Net 30, Net 60, and Net 90 are the most common terms when using trade credit. These terms define the credit period of the trade credit. For instance, Net 30 refers to a period of 30 days after the invoice date, within which the buyer has to make the repayment. Occasionally, suppliers can offer discounts on early payments, which are phrased as “5/15, Net 60” – this means a discount rate of 5% is applicable on the payment if it is made within 15 days of the 60 day credit period. These terms are determined by the industry, the amount of trade credit, and supplier-buyer relationships.

Trade credits can have benefits for both businesses involved in the agreement. Buyers can maintain inventory, increase supply access, and find alternate financing solutions, while suppliers can experience increased sales, better customer relations, and competitive advantages.

We will examine the benefits of trade credit in modern business for both suppliers and buyers.

For the supplier:

Increased sales

Trade credits can incentivize sales from potential buyers. Offering trade credit agreements makes it easier for buyers to make larger or more frequent purchases.

Competitive advantage

Offering trade credit makes the supplier more attractive, in comparison to suppliers that only demand immediate payments.

Customer relations

Extending credit over time can build customer relationships, feeding into the potential of long-term partnerships.

For the buyer:

Improved cash flow

For buyers, trade credit is a short-term financing option. With deferred payment, businesses can generate revenue from the goods and services before making repayment. This deferment increases cash flow in the interim.

Supply access

Trade credit also ensures supply access even in the absence of funds. Businesses can get the goods and services they need to continue their operations.

Alternate financing

For smaller businesses, trade credits are a great alternative to traditional bank-based financing or loan options. International buyers can also benefit from trade credits, as opposed to costly cross-border financing schemes. The lack of interest is a bonus.

Unlike a bank loan, trade credit does not require collateral or interest payments. Trade credit is quicker and more flexible for financing, especially for smaller businesses. Bank loans can be a more predictable funding form.

Let’s look at a table-based comparison between the two:

Trade credit and supplier financing can seem similar in principle, but there are differences in their impact.

Trade credit is when a supplier lets a buyer take goods now and pay later, usually within 30–90 days. It benefits the buyers in managing their business operations, even with limited cash reserves. For the supplier, this means lower cash flow, but can increase their sales and trust factor.

Supplier financing, on the other hand, goes a step further, where a financial institution acts as an intermediary. The financial institution makes the payment upfront, and the buyer pays the financial institution back after a certain amount of time. This reduces the buyer’s risk of default, adding to their creditworthiness. Supplier financing also gives them easier access to the funds that they need.

The decision between trade credit and supplier financing depends on the opportunity cost for the supplier.

Trade credit agreements are made internally between the buyer and seller, with specified, interest-free credit periods. The payments for exchanged goods and services are made after the agreed term. Sellers tend to evaluate the buyer’s financial history when making the agreement.

Let’s look through the key features of trade credit agreements.

Internal agreement

Trade credits are internal agreements between businesses, which include the buyer and the supplier. The supplier agrees to deferred or delayed payment for goods or services.

Eligibility

The approval for the agreement depends on the supplier’s evaluation of the buyer. They might consider factors like the age of the business, its financial history, and repayment record, to determine its eligibility for the agreement.

Credit period

The agreement involves a credit period. It is the duration of payment deferment, and is agreed upon by both parties.

Cash flow

A trade credit agreement is helpful for the buyer party. Businesses are able to free up working capital and manage their liquidity in the short-term.

No interest

Given that the buyer makes the payment within the prescribed period, there are no extra fees or interest charged on the payment amount.

Short-term debt

For businesses, trade credit is considered a short-term debt and financing option.

While a satisfactory financing option for buyers, trade credits can be challenging for the supplying business. This is due to factors such as buyer defaults, the evaluation process itself, strained working capital, and administrative processes. 

Here, we will discuss each of these challenges in greater detail.

Delayed or non-payments

If the buyer fails to pay on time, or defaults on the payment altogether, the supplier’s cash flow is disrupted. Supplier businesses can often rack up losses. Another consequence is the additional strain on supplier-buyer relations.

Evaluating buyers

The task of evaluating the eligibility of buyers for the trade credit itself is challenging. Many factors have to be considered at the same time – whether the buyer’s business is stable, their repayment history, proactive communication, and reliability. A sub-par evaluation can be harmful for the supplier.

Fraud

Fraud is a serious risk when it comes to new or unverified customers. Businesses need to be cautious when authenticating and verifying buyers to prevent this outcome.

Admin burden

Additional paperwork (trade credit invoices, follow-ups) during the payment cycle can increase administrative burden in the short term. Smaller businesses tend to struggle with this workload.

Working capital risk

Lastly, trade credits reduce the supplier’s working capital in the short term. This can limit reinvestment opportunities, financial cushions, and flexibility – which is why trade credits have to be planned carefully.

For leveraging trade credit, businesses can assess the creditworthiness of the borrower, set credit limits and time periods accordingly, monitor their accounts payable closely, and stay aware of global economic and policy changes. Buyers can maintain transparency on their end, too.

Assess creditworthiness

Evaluation is a key step in the trade credit workflow. Maintain precautions by carefully checking each potential buyer for their creditworthiness. Check for credit history, financial statements, and payment patterns, which can reflect the buyer’s stability. 

Establish credit limits and periods

Buyer evaluation should give you an accurate idea of their financial status. Based on this information, it becomes easier to set limits that let you extend credit, without taking on too much risk.

Monitor your money

Stay on top of your financial status using the tools at hand. Send out regular reminders during the credit limit period, follow up on outstanding invoices, keep track of your accounts payable, and set up alerts for all overdue payments.

Manage country-specific risks

If your business trades globally, economic or policy changes can affect your operations. The best practice for such international suppliers is to stay up-to-date on global trends, consult professionals for their global expertise, and use reliable international payment providers.

Likewise, buyers should maintain transparency with the supplier, make repayments within credit limits, and stay informed about global trends for managing international trade credits.

Global businesses can often struggle with trade credits and their complexities. As your business expands globally, you may face challenges such as payment delays, currency conversion uncertainties, frequently changing compliance checks, and difficulties managing your invoices.

When entering a trade credit agreement, consider using an international payment platform that can help you navigate these hurdles.

Xflow is a state-of-the-art partner for your cross-border transaction needs. It offers:

• Seamless, no-limit international payments in over 140 countries
• Transparent pricing, with no hidden fees and the lowest FX rates
• One-click eFIRA on all your transactions, within 24 hours
• Enterprise-grade security, backed by ISO 27001 and SOC 2 certifications
• Single invoices for large payments

By integrating Xflow into your trade credit management, you can optimize your trade credit usage while maintaining operational efficiency.

Trade credit must comply with KYC/AML regulations, local RBI regulations, and secure documentation practices. Whether supplier or buyer, businesses should pay keen attention to these standards. These build trust, mitigate risk, and enable cross-border trade.

Here are a few considerations to keep in mind:

1. KYC/AML

Know Your Customer regulations verify the identities of customers and business participants. KYC compliance can cut down on fraud risks. Similarly, Anti-Money Laundering regulations let businesses monitor and report suspicious financial activities, and maintain all transaction documentation. These frameworks, in conjunction, can create more secure environments for trade credit agreements.

2. RBI regulations

RBI is the overseeing authority in India for trade credit transactions. Businesses should stay up-to-date with new circulars to prevent regulatory penalties.

3. Secure documentation

Proper documentation of the trade credit process is an important security consideration, too. All agreements, invoices, and compliance records should be appropriately maintained. Digital platforms and tools are increasingly being used to achieve this.

Future trends in the trade credit space include an increase in automated workflows, predictive analytics for anticipating risks and opportunities, and a change in the global economic landscape.

Digitization and economic growth have affected the finance industry on a global level. Here are the trends bound to affect trade credit tech and adoption in the future:

Automation

Automation, especially in terms of artificial intelligence and machine learning-assisted tools, is rapidly growing. It is reasonable to expect finance and tech tools to rely on automation, now more than ever. With automation, multiple trade credits can be kept in check, automatic notifications and reminders can be sent out, and potential breaches can be identified ahead of time.

Predictive analytics

AI is also being used for predictive analytics, which can process large amounts of historical and contemporary data, and predict conditions like potential fraud, default, and changes in market demands. With these tools at hand, businesses will be better equipped to make credit decisions in the future.

Monetary ease

Global economic and trade growth is also expected to affect trade credit adoption. With the alternative financing market expected to grow at a rate of 21.1% by 2028, trade credit agreements are likely to become a popular financing option, too.

For businesses seeking to stay on top of these trends, while scaling their operations internationally, Xflow is an ideal partner. Consider trying the platform today to find out how it can help with your cross-border transactions.