Trade Credit: Meaning, Advantages and Disadvantages

Trade Credit

Refers to the credit that a customer gets from suppliers of goods in the normal course of business. In practice the buying firms do not have to pay cash immediately for the purchases made. The deferral of payments is a short term financing called trade credit.

It is particularly important to small and fast growing firms. Trade credit is mostly an informal arrangement, and is granted on an open account basis. A supplier sends goods to the buyer on credit which the buyer accepts and this in effect agrees to pay the amounts due on per sales terms in the invoice.

Advantages

1. Easy availability – Trade credit is relatively easy to obtain
2. Cheap source of finance
3. Flexibility – Trade credit grows with the growth in firm’s sales.
4. Informality – It does not require negotiations and formal agreements
5. No restrictive covenant-It is convenient and informal

Disadvantages

1. Loss of cash discounts. If cost discount is lower than interest paid on other sources of finance then trade credit will be beneficial and vice versa.
2. The annual opportunity cost of foregoing cash discounts can be very high. Therefore a firm should compare the opportunity cost of trade credit with the cost of other sources of credit while making its financing decisions.