Trade credit

Trade credit exists when one provides goods or services to a customer with an agreement to bill them later or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in a going concern[?] because it can reduce the required capital investment to operate the business if managed properly.

There are many forms of trade credit in common use. Various industries use various specialized forms. They all have in common the collaboration of businesses to make efficient use of capital to accomplish various business objectives.

For example:

You run an ice cream stand under a franchise which agrees to provide you with ice cream stock under terms Net 60 with a ten percent discount on payment within 30 days and 20 percent discount on payment within 10 days. This means that you have 60 days to pay the invoice in full. If you sell sufficient ice cream at your markup within a week, then you can dispatch a check for the 80% of the invoice and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a low cash flow month then you may decide to pay 90% within 30 days or use the money another 30 days and pay the full invoice amount within 60 days.

The ice cream distributor can do the same thing. Receiving trade credit from milk and sugar suppliers on terms of Net 30 2 percent discount if paid within ten days, means they are apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would they do this? First remember they have a substantial markup on the ingredients and other costs of production of the ice cream they sell to you. There are many reasons and ways to manage trade credit terms for the benefit of a business. The ice cream distributor may be well capitalized either by steady profits or recent new investment and looking to expand its markets. In this case it is aggressive in attempting to locate new customers or help them get established. Having experienced a few customers going out of business from cash flow instabilities it has decided on its financial terms to accomplish two things:

1. Allow startup ice cream parlors the ability to mismanage their investment in inventory a bit while learning their markets without having a dramatic negative balance in their till or bank account, putting them out of business. This is in effect a short term business loan made to help expand the distributor's market and customer base.
2. By tracking who pays when, the distributor can see potential problems developing and take steps to reduce or increase the allowed amount of trade credit it extends to prospering or faltering businesses. This limits the exposure to losses from customers going bankrupt and never paying for the ice cream delivered. Better a $5,000 loss than a $30,000 loss.