Trade credit is an arrangement between a seller and a buyer, where the seller allows the buyer to make purchases now and pay at a later date without incurring an interest charge. This arrangement allows the buyer to sell the goods and earn sufficient cash to pay off its debt to the seller. A common time period for trade credit is for buyers to pay 30 days after the shipment date.
A seller may offer trade credit for several reasons, including the following:
- Industry practice. It may be accepted practice within an industry to offer buyers a certain number of days in which to pay, such as 30 days from the shipment date.
- Competitive posture. A seller may offer unusually long payment terms in order to increase its sales to customers that value such terms. However, this offering is more likely to increase sales to customers that are in poor financial condition, which increases the risk of incurring bad debts.
- Buyer support. Customers may be suffering during an industry downturn, so the seller offers them extended trade credit in order to keep them afloat. By doing so, the seller retains a base of customers and earns their goodwill, which may translate into increased customer loyalty over an extended period of time.
A seller does not usually allow more than a minimal amount of trade credit to a new and unproven customer. Instead, new customers must prove their financial reliability with a series of timely payments, as well as by forwarding their audited financial statements to the seller. Once a payment history has been established, the amount of trade credit offered to a customer will be gradually increased to cover its ongoing purchases from the seller.
If a buyer does not pay the seller within the prescribed time period, the seller may restrict the amount of trade credit allowed, and may also require the buyer to pay an interest charge or late fee.