What is Trade Credit?
Trade Credit refers to the credit that the customer gets from suppliers of goods in the normal course of business. Buying firms do not requires to pay the cash immediately for the purchases they made. This delaying in payment is a short – term financing called trade credit. It is one of the major source of financing.
The account of this short term financing in India is about one – third. Small firms are mostly dependent upon trade credit as they found it quite difficult to raise fund from banks or other sources in the capital market. It is an informal arrangement which is granted on an open account basis.
Example of Trade Credit
A supplier sells the goods to the buyer on credit which the buyer accepts. Thus the buyer agrees to pay the amount due as per sales in terms in the invoice. However, he does not formally acknowledge as a debt, he does not sign any legal instrument. Once the trade links has been established between the buyer and seller, they have each other’s mutual confidence. And thus this becomes a routine activity. Open account credit appears as sundry creditors on balance sheet of buyer.
In addition to this, this can also take the form of bills payable. When the buyer signs a negotiable instrument that is bill, it appears on the balance sheet of buyer as bills payable.
Benefits and Advantages of Trade Credit
Easily Available – In comparison to other sources of finance, it is easily available. The easy availability is important from the small firm perspective which generally face difficulty in raising funds from the capital markets.
Flexibility – The expansion in the firm’s sales causes its purchases of goods and services to increase which is automatically financed by trade credit. On the contrary, if the firm’s sales reduce, purchases will decline and consequently it will also decline.
Informality – It does not require any negotiations and formal agreements. Hence does not involves restrictions which are usually parts of negotiated sources of finance.