Trade Credit: Advantages and Disadvantages
What is Trade Credit?
Trade credit is credit given by one merchant to another for the purchase of products and services. Trade credit allows for the purchase of materials without the need for immediate payment. Such credits appear as ‘sundry creditors’ or ‘accounts payable in the records of the buyer of goods. Business organisations frequently utilise trade credit as a form of short-term finance.
It is offered to customers that have a good financial status and reputation. The amount and period of credit provided are determined by factors, such as the purchasing firm’s reputation, the seller’s financial status, the volume of purchases, the seller’s payment history, and the degree of market competition. Trade credit terms might differ from one industry to another and from one customer to another.
Advantages of Trade Credit
The advantages of Trade Credit are as follows:
- Business Growth: The two main obstacles to worldwide business expansion are: The capacity to pay vendors for products or services delivered, and the risk of non-payment. Trade credit is a kind of short- to medium-term working capital that offers security on the product or service being exported or imported, enabling multinational enterprises to overcome these hurdles more effectively. As a result, business growth is facilitated.
- Continuous Source: Trade Credit is a continuous and convenient source of funds, which is easily available to firms.
- Easily Available: If the creditworthiness of the customers is known to the seller, trade credit may be readily available to customers.
- Increase in Sales: Trade Credit can be used if an organisation wants to increase its inventory level in order to meet the expected rise in the sales volume in the near future.
- No Charge on Assets: It does not create any charge on the assets of the firm while providing funds.
Disadvantages of Trade Credit
The disadvantages of Trade Credit are as follows:
- Cash Flow Effect: The most obvious effect of trade credit is that merchants do not receive instant payment for their goods. Sellers have their own costs to pay, and offering credit terms to buyers disrupts their financial flow.
- Overtrading: Trade Credit allows businesses to avail credit facilities easily, which may induce a firm to indulge in overtrading, which may add to the risks of the firm.
- Limited Funds: Only a limited amount of funds can be generated through trade credit, so it is not very useful if a business required heavy funds.
- Investigate Creditworthiness of Customers: A vendor who gives credit to consumers, like a bank examines their credit ratings. This requires both money and time. Obtaining company credit reports, such as Dun & Bradstreet, is expensive, and calling references takes time. A vendor may need to recruit an additional person with credit analysis expertise to assist in making choices about extending payment terms.
- Financing Accounts Receivable: The seller must finance these receivables since credit terms have been extended to buyers. To receive trade credit, a seller may have to rely on his own suppliers, borrow on his bank line of credit, or use the company’s accumulated retained earnings. Each of these approaches has an inherent capital cost.
- Increase in Cost: Trade financing, like any other loan instrument, has a cost because trade financing is only charged on the particular trades carried out under the facility. It is essential to comprehend the profit margins on trades. If a company understands its profit margins and costs, the financing cost may be included in the trade costing. It is also more costly than other sources of raising money.
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