Trade Credit | What is it, How does it work & How can your business offer it?

Updated:

January 4, 2024

What is trade credit?

Trade credit, or trade finance, is a financial arrangement in B2B commerce where businesses purchase goods or services on credit and pay at a later date.

This is particularly important for SMEs with variable cash flow – over 75% of SMEs have cashflow worries.

The ability to purchase goods and supplies is key to their ability to generate revenue – this arrangement enables businesses to source the goods they need while maintaining liquidity and manage cash flow more effectively in the short term.

How does trade credit work?

The basic mechanism of trade credit is simple:

A buyer purchases goods or services on a deferred payment basis
The seller issues an invoice with a set payment term, typically 30, 60, or 90 days.
The buyer utilises the acquired goods or services in their business operations before the payment is due.
Upon the invoice's maturity, the buyer completes the payment.

What can vary greatly is how the selling business manages the credit – which depends on their business model and cash position. For example, a company with more robust cash reserves might offer more generous credit terms, like 90-day payment periods, to foster long-term relationships and customer loyalty, whereas a business with tighter cash flow might restrict credit terms to 30 days to ensure quicker return of funds.

What are the different kinds of trade credit?

Given the wide variety of business types, cash management strategies and financing arrangements, a multitude of versions of trade finance have developed over the years.

Open Account: The buyer pays after receiving goods, common in long-standing business relationships with pre-existing trust.
Cash-on-Delivery (CoD): Payment is made upon delivery, minimising credit risk for the seller.
Instalment Credit: Payments are made in regular instalments, possibly after an initial down payment.
Revolving Credit: Similar to a credit card, with a credit limit set by the seller in line with their risk tolerance and periodic repayments.
Consignment: The seller retains ownership of goods until they are sold by the buyer.
Trade Acceptance: Involves a bill of exchange that specifies future payment dates.

Each type serves different business scenarios and risk profiles, offering flexibility in managing business finances.

Is trade credit the same as BNPL?

Buy-now-pay-later (BNPL) has been an increasingly popular method of credit for consumers in recent years, raising expectations for B2B buyers for customer experience and convenience.

In the world of B2B transactions, this concept has existed for much longer, though it’s had a different name – trade credit. Fundamentally, both BNPL and trade credit operate on the same principle: providing buyers the option to purchase now and pay later.

What has changed in recent years is the digitisation of this concept. Advances in technology, particularly in embedded finance, have blurred the lines between traditional trade credit and BNPL. Now, digital platforms such as Kriya enable businesses to offer seamless, BNPL-like solutions not only at online checkouts but also in offline sales channels.

What is the cost of Trade Credit?

The cost of trade credit is the implicit interest rate that a buyer pays for the ability to delay payment.

This cost is typically not explicitly stated, but it is embedded in the price of goods or services.

The effective cost of trade credit can vary depending on the terms of the credit agreement, the buyer's creditworthiness, and the seller's financing costs.

What are the benefits of trade credit for businesses?

Offering trade credit is an essential advantage for many businesses in the B2B sector, enabling them to grow and scale by improving the purchasing experience for customers.

Key benefits include:

Winning new customers: Trade credit enables more customers to access your services, making your products more affordable and enabling them to purchase on their terms.

Entering new markets: Entering a new market requires building new relationships with customers – which can be a challenge for offering credit due to a lack of existing trust. Using a trade credit solution streamlines decisions on credit terms and foreign regulation, while minimising FX fees.

Increased order size: For new and existing customers, trade credit makes it easier for customers to buy from you compared to competitors by giving them the added liquidity to increase their basket size and incentivising higher value orders.

What are the Risks of Trade Credit?

Traditional trade credit effectively requires businesses to give their customers an interest-free loan for the duration of the deferred payment. While this makes life easier for customers, it also brings challenges for the business – especially those using their own working capital to fund credit off their balance sheet.

Risk of Delayed Payments: When businesses allow their customers to defer payment, they may encounter situations where payments are not received within the agreed timeframe, which can disrupt the seller's cash flow and operational planning.

Assessing Creditworthiness: Determining the creditworthiness of customers is a significant challenge. It requires the ability to accurately assess the financial health and payment history of their customers. Inaccurate assessments can lead to extending credit to customers who may not be able to fulfil their payment obligations.

Non-Payment Risk: The most severe risk associated with trade credit is the potential for non-payment if a customer becomes insolvent or otherwise unable to pay. This can be a major risk in times of economic uncertainty.
Fraud: Offering credit to a buyer – particularly a new one – opens the door to the customer simply taking the credit and disappearing. Robust authentication and KYC checks, as used in the financial industry, play a key role in mitigating this risk, but this can add a major administrative burden for businesses. Specialist financing products such as Kriya, however, can streamline this process for non-financial sellers to offer credit more efficiently.
Administrative Burden: Managing trade credit can create extra work for finance teams, keeping track of various payment terms, invoices, and ensuring timely payments. This is especially challenging for smaller businesses that may not have dedicated financial teams.
Working capital risk: Offering your own cash prevents that money from being reinvested in the business for the duration of the credit, reducing the company’s financial flexibility and tying up valuable capital.

How to offer Trade Credit

The decision of how to offer trade credit involves selecting the right financial instrument to suit your business and your clients.

Key considerations include assessing customer creditworthiness, setting clear credit terms, and determining credit limits.

The right terms and limits will depend on the capital available in your business, the reliability of your customers and your access to finance.
This can be challenging for businesses attempting to scale rapidly, with the need to build trust with customers, manage the credit book and implement repayments across a growing base.

Effective implementation also requires oversight from internal teams, often necessitating dedicated tools for monitoring and administration.

Due to the complexity of offering credit, a growing number of B2B businesses are turning to digital trade credit through third-party providers such as Kriya.

What are alternatives to trade credit?

Bank loans: Trade credit is typically more accessible than bank loans, which often require collateral, extensive documentation and credit checks.
While bank loans provide a lump sum of money upfront, trade credit is used transactionally, offering flexibility for specific purchases or projects.

Equity Financing: Equity financing involves selling a portion of the business to raise funds, contrasting with trade credit, which does not dilute ownership. Trade credit is a form of debt but without the interest rates typically associated with equity financing or bank loans.
Factoring and Invoice Financing: Unlike factoring or invoice financing, where businesses sell their receivables to a third party at a discount, trade credit allows businesses to maintain control over their entire sales ledger.

Trade Credit FAQs

What Are the Most Common Terms for Using Trade Credit?

Trade credit terms typically include the following key elements:

Payment Duration: The most common payment terms are 30, 60, or 90 days, but they can vary based on mutual agreements between the buyer and seller.
Credit Limits: A predetermined limit on the amount a buyer can purchase on credit.
Repayment Structure: Detailed agreement on how ( in instalments or a lump sum) and when the repayment should be made.
Late Payment Penalties: Specifics on any fees, penalties, or interest rates applied for late payments.
Eligibility Criteria: Criteria defining which businesses qualify for trade credit, often based on creditworthiness and financial history.

Is Trade Credit Long Term?

Trade credit is generally considered a short-term financing solution.

Typical arrangements require repayment within a 30-90 day period, aligning closely with operational cash flow cycles of businesses. This short-term nature distinguishes trade credit from long-term financing options like loans or equity financing.

Who Bears the Cost of Trade Credit?

The cost of trade credit is typically borne by the seller.

This includes delayed cash inflows and potential financing costs incurred due to offering credit.

The cost can also be indirectly factored into the pricing of goods or services. There may also be costs related to risk management, such as trade credit insurance.

Does trade credit have interest?

Trade credit is generally interest-free within the agreed payment term. This means businesses can use the credit without incurring additional costs if they pay on time.

If payments are made after the agreed term, interest or penalties may be charged, similar to late payment fees.

This feature makes trade credit a more attractive option compared to traditional loans or credit lines that accumulate interest over time, but adds risk for the seller

Is Trade Credit Expensive?

Compared to other forms of short-term financing, trade credit is usually more cost-effective, especially since it often comes without interest charges.

However, it can be expensive for the seller providing the credit, depending on their financing arrangements to provide the capital for sellers and the operational costs involved in managing and administering trade credit, such as accounting, billing, and credit risk assessment.

Offering Trade Credit with Kriya

The advent of online retail B2B ecommerce through digital platforms has transformed the way businesses offer, assess and recoup trade credit, using real-time data, APIs and automated assessment.

This includes B2B BNPL services and multi-channel credit tools such as Kriya which enable businesses to offer credit instantly, with fast digital underwriting, without using their own capital.

The traditional way of offering credit to buyers involves funding credit from the sellers’ own balance sheet.
This risks businesses own capital, creates extra work for finance teams and prevents liquidity from being deployed elsewhere in the business.
Working with a digital trade credit provider like Kriya removes this risk. Kriya connects buyers with external financing instantly, whether it’s PayLater or leveraged invoice financing, sellers are paid immediately, and Kriya handles the repayment process for clients, as well as reducing risk through integrated authentication and KYC.

To find out more about how digital trade credit can support your growth, get in touch with our team today.