Definition

Trade credit is a form of commercial financing in which sellers permit buyers to purchase goods of service and pay for it later.

Description

A vital form of business funding, trade credit allows them to purchase goods and services now and pay for them later. It improves cash flow management, cultivates connections between suppliers and buyers, and frees up capital for other corporate uses. Businesses can maintain inventory levels without an immediate capital outlay by utilising trade credit. 

This approach frequently involves negotiated payment terms, which may save expenses by offering early payment discounts or increasing cash availability for operational requirements.

Importance of line of trade
 

These are the reasons for the importance of line of trade:

• Market Understanding: Knowing the line of trade helps businesses understand market trends, customer needs, and competitive dynamics, leading to more informed decision-making for trade credit.
• Product Development: The line of trade guides in the creation of products or services tailored to specific industry demands. It helps to ensure relevance and attractiveness for target customers.
• Brand Positioning: For clear identification of business, line of trade assists in effectively positioning the brand within the market. The main idea is to distinguish the business from competitors.
• Networking Opportunities: Being part of a specific line of trade, opens doors to industry-specific networking opportunities. It also helps businesses expand operations after collaborations and partnerships which further enhance business growth and innovation.

How to start credit trading?

These are the ways you can start credit trading:

1. Conduct Market Research:
   • For credit trading, start with thorough market research to understand the credit trading landscape widely.
   • Identify potential markets, target customers, and competitors.
   • Assess the demand for credit trading services and the risks involved.
2. Create a Business Plan:
   • Then, you can develop a comprehensive business plan. Design your business plan that can outline the business's objectives and strategies.
   • Include financial projections, funding requirements, marketing strategies, and operational plans.
   • After a business plan, you can craft a unique selling proposition (USP) and competitive advantage.
3. Register Your Business:
   • Decide a suitable business structure that aligns with your business goals. Register either a sole proprietorship, partnership, or a corporation. Once decided, register your business name.
   • After you decide on the structure, you must find ways to get the required permits and licences for your industry and location.
   • Ensure compliance with local, state, and federal regulations.
4. Set Up Financial Systems:
   • For transactions, open an account to manage business transactions to keep the funds separate from personal funds.
   • Establish accounting and bookkeeping systems to track transactions and monitor cash flow.
   • Implement credit management policies, including credit limits, payment terms, and interest rates.
5. Develop Credit Policies:
   • Create credit policies outlining the terms and conditions for extending credit to customers.
   • Include criteria for creditworthiness assessments, credit limits, and payment terms.
   • Establish procedures for handling late payments and defaults.
6. Build Relationships with Suppliers and Customers:
   • Negotiate favourable credit terms for your purchase after developing solid relationships with suppliers.
   • Identify your potential customers and contact them to see who may benefit from your credit trading services.
   • Communicate the benefits of credit trading and build trust through transparent and consistent practices.
7. Implement a Credit Management System:
   • Invest in a reliable credit management system to automate and streamline credit processes.
   • Use software to track customer creditworthiness, monitor credit limits, and manage collections.
   • To stay aligned, you must regularly review and update your credit policies to ensure efficiency and minimise risks.

Types of trade credit

These are the types of trade credit that small businesses must know:

Types of Trade Credit: A Detailed Overview

• Open Account:

The most common form of trade credit is where goods are shipped and delivered even before the payment is due. The seller releases an invoice to the buyer but the buyer is expected to pay within the agreed-upon terms, typically 30, 60, or 90 days.

Simplifies transactions and fosters long-term relationships. It provides buyers with the flexibility to manage their cash flow effectively. Sellers bear the risk of non-payment or delayed payment and this can impact their cash flow and financial stability.

• Instalment Credit:

Under instalment credit, a buyer agrees to pay the seller in fixed instalments over a specified period. Payments are usually made monthly or quarterly.

Instalment Credit allows buyers to spread payments over time, making large purchases more manageable. Sellers can attract more customers by offering flexible payment options.

However, careful credit assessment is required to ensure buyers meet payment obligations. Sellers must manage the risk of default and maintain cash flow during the installment period.

• Promissory Note:

A formal written agreement where the buyer promises to pay the seller a specific amount at a future date. It includes details of the amount, interest rate, and payment schedule.

A promissory note provides a legally binding commitment, giving sellers greater assurance of payment. It can include interest and provide additional revenue for sellers.

Enforcing payment may require legal action if the buyer defaults. The seller must manage the risk of non-payment and potential legal costs.

• Bill of Exchange:

A negotiable instrument in which a seller (drawer) orders the buyer (drawee) to pay a specified amount on a future date. The buyer accepts the bill, acknowledging the debt.

The bills of exchange provide a formal and legally binding payment agreement. It can be discounted or sold to a bank or third party, providing immediate cash flow for the seller.

Requires careful assessment of the buyer's creditworthiness. Sellers bear the risk of non-payment and must manage the discounting costs if selling the bill to a third party.

• Trade Acceptance:

Like a bill of exchange, the buyer formally accepts the draft the seller drew, promising to pay later. It is a non-negotiable instrument.

Provides a clear commitment from the buyer, enhancing the seller's confidence in receiving payment. It simplifies credit terms and clarifies payment obligations.

A non-negotiable nature means it cannot be quickly sold or transferred. Sellers must carefully evaluate the buyer's ability to pay and manage the risk of default.

• Consignment:

In a consignment, the ownership of the goods rests with the seller until they are sold by the buyer. The buyer will then pay only for the goods sold, and she/he is free to return the unsold goods.

Reduces inventory risk for the buyer, encouraging them to stock more products. Sellers can reach new markets without immediate payment requirements.

Sellers bear the risk of unsold inventory and delayed payments. It requires strong trust and communication between the seller and buyer.

• Letters of Credit:

A Letter that guarantees payment to the seller once all the conditions are met. It is issued by the bank on behalf of the buyer. Upon meeting specified conditions, such as delivery of goods and presentation of documents.

Provides a high level of security and assurance for both parties. It reduces the risk of non-payment and facilitates international trade.

This can be costly due to bank fees and requires detailed documentation. Sellers must ensure compliance with all terms and conditions to receive payment.

Example

Suppose a shop named "Shree Electronics" specialising in consumer electronics. After the festive Diwali season, the store owner, Rajesh, decides to stock up on the latest gadgets and home appliances. He placed a substantial order with his primary supplier, "TechSupplies India," for ₹10,00,000 worth of merchandise.

TechSupplies India offers Rajesh trade credit with terms of Net 45 days, allowing him to defer payment for 45 days from the invoice date. The September 1st invoice indicates that Rajesh must pay the total by October 16th. This arrangement enables Shree Electronics to receive and sell the goods during peak shopping without an immediate financial burden.

By utilising this trade credit, Rajesh ensures his store is well-stocked for the Diwali rush, optimising sales while maintaining healthy cash flow. This benefits Shree Electronics and TechSupplies India, as they receive a significant order, reinforcing their business relationship with Shree Electronics and securing future transactions.

FAQ

What is trade credit insurance?

An insurance policy that protects your business from losses due to unpaid invoices by insuring against customer insolvency or non-payment is trade credit insurance.

What is trade credit finance?

Using outstanding invoices as collateral to secure loans or other financial products is called trade credit finance. It helps to convert unpaid customer invoices into cash.