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What is Trade Credit in Business? - Definition & Types

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Trade credit is similar to consumer credit but it is between businesses. Trade credit allows a retailer to take possession of inventory today and pay for it at a later date. The process will be illustrated with simple examples and a formula.

Inventory Finance

JoAnne and Jerry are the owners of a fine jewelry store in the local mall. They took a big chance when they started the store, but they have built it into a successful family-owned business, something they are very proud of. Like most small businesses, the first major problem they faced was getting some inventory into the store to sell.

It was impossible for them to get financing at first since they were so new. They had to borrow from family members and friends, and also max out their credit cards to pay for enough jewelry to fill in the displays. Once that merchandise started to sell though, they knew that things were going to work out and they were on the road to success! Once the store was established and successful, Jerry and JoAnne were able to finance new inventory orders the way most retail businesses do, and that is by using trade credit.

Trade Credit

Trade credit is similar to the kind of credit consumers use, except it's between a retailer and the supplier who sells them inventory. It allows the retailer to get the inventory items today and pay for them at a later date, hopefully after the purchased inventory items have been sold! When they sell their jewelry, JoAnn and Jerry can either pay back the debt early and take advantage of available savings from discounts, or use the cash for other needs until the balance is due.

Trade Credit Terms

There are many types of trade credit terms; they are negotiated between the retailer and the supplier they are buying from. Common credit terms look like this:


Credit Terms 1


The 2/10 part means that there is a 2% discount if the balance is paid within 10 days from the receipt of the merchandise. The net 30 part means that the full balance is due in 30 days. Usually, there are late fees and penalties if the balance is paid after the 30 days have passed. For many retailers financing hot selling products, getting the discount for paying within 10 days is especially appealing because they feel that is all of the time they will need to sell the merchandise and pay the money back with the discount!

Here's the formula for the amount to pay when taking that early payment discount:


Repayable


JoAnne and Jerry took the 2% discount on repaying a $10,000 jewelry order. The amount they repaid was $10,000 * (1 - .02) = $10,000 * 0.98 = $9,800.

Trade credit also becomes a short-term financing tool. As merchandise is sold, the proceeds can be used for the retailer's other needs until it becomes due at the net date

Longer Credit Terms

Jewelry isn't like most other retail products: It's a bigger purchase for most people, and that means it takes longer for JoAnn and Jerry to sell it. Jerry has become quite good at negotiating longer terms for their jewelry purchases. Their latest purchase had the following terms:


Credit Terms 2


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