Purchasing required materials, products, and other relevant items from suppliers on account with the agreement of making payment after a certain time period in further is known as trade credit.
This includes open account where there is no written or formal document for credit transaction between two parties and notes payable where there will be maintaining written and formal document signed by both parties.
A major source of funds for U.S. business firms, trade credit traditionally provides approximately 6 percent to 12 percent of the firm’s total financing, depending on the kind of business firm is in and the size of the firm.
Wholesale and retail companies have historically been heavy users, as have manufacturers.
Small firm considerations
Small companies tend to rely on trade credit more than large ones because these companies are generally less able to access the capital and money markets, where trade credit can be obtained readily by any firm with a reasonable financial record.
Advantages of Trade Credit
1. Availability: Except for firms in financial trouble, trade credit id almost automatic, and no negotiations or special arrangements are required to obtain it. This availability is important to smaller companies that may have difficulty obtaining funds elsewhere.
2. Flexibility: If the firm’s sales increase, causing its purchases of goods and services to increase, trade credit will grow automatically. Likewise, if the firm’s sales decrease, causing purchases needs to drop, trade credit will likewise decrease.
3. Few or no restriction: In general, trade credit terms are much less restrictive than those of negotiated sources of fund. As we will see, when the firm negotiates for short-term funds, it may have restrictions imposed on its financial activities by the lenders.
Disadvantages of Trade Credit
1. Suppliers may not be agreed to supply required items on credit for the time period.
2. Sometimes it may be more costly for the business.