“To contract new debts is not the way to pay old ones.”

~George Washington~

What is trade credit?

Businesses operate in diverse economic scenarios where business owners hanker to conquer international markets and access an ocean of short-term as well as long-term finance. The indispensable need for cash flow to sustain long-term business relationships gratifies along with business-to-business trade credit. For Example, A buys goods from Seller B today and both of them agree that A will pay for the goods after certain days and that no security will be kept with the supplier for this credit purchase. Such a transaction of credit is the underlying of the Trade Credit world. The world has come far in this process of modern trade.

Apocalyptic concern - Large and Small Businesses

The trade-credit definition is an umbrella of net terms for the day-to-day financing needs of suppliers and buyers. A trade transaction typically involves cash flow from the sale or purchase among domestic or international businesses. However, whenever a supplier makes an invoice the buyer and seller agree on a deferred date for making payment interest-free or on certain terms and conditions of payment. Small businesses make payments to suppliers, these suppliers can be big or small. If big, they employ various terms and conditions on the buyer for financing and invoicing. If small, the supplier can be at risk of early payment discounts which is harmful to its profitability. There is no security to the supplier except for relying on the reputation of the buyer in the market based on the payment history.

Insider trading
CC BY-SA 4.0 | Image Credits: https://commons.wikimedia.org | Harshita BN

Cost-effective trade credit

Trade-credit is the most worthwhile option of finance for a major chunk of market participants including small businesses. The trade-credit is available to all businesses just in a go-to to increase the cash flow. The number of days and terms of invoicing agreed upon between the parties depending on the nature of business. However, there are costs associated with these short-term peer-to-peer financing options that are relatively easier to bear than borrowing from Institutional lenders. The cost of trade-credit is zero for many small businesses to help them survive in competitive environments. The boost for short-term growth and kick-starting the business relationships and stable cash flows are the perks for the buyer. The free flow of trade across the globe has widened the scope of growth to the forex sector. Now lending of Letters of Credit (LCs) is a part of the regular operation in banks thereby increasing their revenue. Trade Credit is a boon for stable businesses seeking short-term funds for expansion and growth.

Accounting for trade credit

The credit is accounted for by both the seller and the buyer in their respective books of accounts. The seller accounts for the invoice date and amount as accounts receivable in his balance sheet. The seller will record the revenue earned and the expenses related to the sale. Sometimes the seller may have to consequently write off as bad debt or often write down some discount according to the invoicing terms. There maybe late payment penalties or maybe not.

The purchaser of goods/services will record the purchases and add them to the inventory besides record the net terms invoice of purchase as a trade payable. If the seller charges any interest for the credit or for the late-paying after a certain period then it will be classified as an expense of the buyer and an income of the seller.

Trade credit insurance

The large MNCs when engaging in trade credit usually take insurance for the big transactions to manage the risk of losses in case of any default. The supplier takes insurance as soon as the invoice is prepared and payment is deferred as short-term financing is often enacted by these companies especially to small businesses. During the previous decade, there has been a radical global movement towards digitalization in the Insurance sector. Today any seller can take advantage of Fintech in a matter of clicks. By undertaking primary research on the available options and assessing feasibility, risk managers do an incredible job. Just completing the formalities, providing necessary documents, and the insurance is done.

Institutional trade credit

The main purpose of trade credit is to accelerate the ease of doing business along with a reduced risk of insolvency. Banks and Financial institutions being an incredible source of finance especially when it comes to foreign currency credit. The major chunk of Import and Export trade is based on Letters of Credit (LCs) and Bank Guarantees (BGs) as a must for every transaction of Export/Import. This is also covered by Transit Insurance to cover the risk of loss. This process of lending by banks involves a critical examination of the whole transaction and its various aspects and rules and regulations.

Big MNCs sign major tie-ups with each other for trade credits. The optimal combination of financing and risk management is the output of the intelligent dealings and fascinating growth rates of some companies.

Domestic Trade is accelerated by trade credit to a great extent. The major commercial projects and ventures are tall and endless fruit-bearer of trade credit. It is all a result of the concentrated effort of the Central banks and IMF that has facilitated major ventures across the globe.

Fintech in trade credit

The small trading establishments co-existing along with large companies are sometimes unable to get financing from banks because of Basel iii and IV requirements. However, this gap is bridged by cross-border and Soonicorn Fin Techs who have made the process of appraisal, documentation, and KYC assurance very reliable and transparent. One such example is Mitigram which is the world's first global trade finance corporation. It is a brilliant example of leveraging foreign trade.

The SWIFT 700 series messaging, UC and UR protocols are eminent worldwide as a staple feature of the International Trade. However, over the years the involvement of these tedious functions has been slow-paced as a result of massive disruption by Fintech Innovators. The Trade Credit sector has now become an ocean full of opportunities with a unicorn potential to swap bank funding in the coming eras.

Blockchain and trade credit

As per the reports of Global Trade Survey 2020 conducted by the International Chamber of Commerce trade and trade finance, it is much noticeable that there is an uncertainty to a great extent accounting to the Global impact of Covid-19. The lockdowns and Work from home culture have shifted a trend towards digital solutions and blockchain technologies.

A major number of banks have expressed concern over the lagging trade turnover threatening their Capital Adequacy and this is where Blockchain Technology comes into a priority to streamline the flow of funds to the credit sector from increased access to various potential flowmakers. The flow of documentation transparently from one network participant to another reducing the risks of concealment of facts and frauds.

Trade finance consortiums

Indian Banks' Blockchain Infrastructure Co Pvt Ltd (IBBIC) is an RBI regulated revolutionary consortium of 15 banks in

India coming together to adopt blockchain technology for the processing of Inland Letters of Credit (LCs). This marks the new leap in the digitization of Trade Credits. It is a unified, transparent shared network of banks that will share data and automate lending. This will maintain a real-time record of supply chain stakeholders curbing the instances of deceit and forgery. It is expected to launch a digital platform in a year streamlining the banking sector of the economy.

Context and Application

This term is used to gain knowledge about wider terms including:

  • Masters in Banking and Financial Management
  • Masters in Business Administration

Practice Problems

  1. A sold goods costing $50,000 to B at a credit of 45 days on 18/08/2021. Calculate the interest payable when the buyer makes payment on the 85th day if the seller has a policy of charging interest @8% p.a. beyond 45 days.
    1. 1000
    2. 741.22
    3. 584.65
    4. 438.86

Answer- d-438.36

Explanation- Interest = 5000 × 8100 × 40365 = 438.36

2. Tesla is a finance manager of a company. He is considering increasing its trade volume, which is a more cost-effective source of funds when credit is easily available in the market?

    1. Credit purchase from a seller
    2. Borrow from banks
    3. Issue right equity shares
    4. Sell some assets

Answer-a-Credit purchase from a seller

Explanation- Credit purchases from the seller are the most cost-effective sources of funds.

3. What does 4/13 net 60 mean in trade terms?

    1. 4% discount if payment is made within 13 days else full amount is due in 60 days.
    2. 4% discount if payment is made within 13 days else discounted amount is due in 60 days.
    3. 4% discount if payment is made within 60 days.
    4. (4/13)% discount if payment is made within 60 days.

Answer-a- 4% discount if payment is made within 13 days else full amount is due in 60 days.

Explanation- Gross method is used for deciding the payment terms where a cash discount is given if payment is made prior to the due date.

4. Inventory is in full ownership and possession of the buying party in which type of transaction?

    1. Goods-in-Transit
    2. Credit Sale
    3. Sales Return
    4. Approval Basis

Answer-b-Credit Sale

Explanation- The full ownership of the goods lies with the buyer only in the case of Credit Sales. In all the other situations, they are of partial ownership based on the stage of the sale.

5. When is the payment required to be paid to the seller in case of import of goods where the agreement stipulates advance payment?

    1. Before Shipping of goods
    2. On placement of an order for buying goods
    3. On domestic clearance of goods for storage in a warehouse
    4. On receipt of Shipping Bill

Answer- a- Before Shipping of goods

Explanation- Whenever an advance payment is agreed upon then it doesn't matter at which stage payment will be made. Since it is specified, the payment will be made before shipping the goods.

Common Mistakes

The students often misunderstand Trade credit to be a smaller term. It is a wider term in terms of its cope. While studying this topic it is advisable to have a clear understanding of various forms of financing.

  • Short Term Borrowing
  • External Commercial Borrowings
  • Credit Rating
  • Credit Spreads
  • Currency Swaps
  • Letter of Credits (LCs)

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