What it means
When a supplier ships $50,000 of stock on 60-day terms, it has effectively lent the buyer $50,000 for two months without paperwork, security or an interest rate. That is trade credit, and it appears on the buyer's balance sheet as trade payables and on the seller's as trade receivables.
The appeal for the buyer is obvious: goods can be sold and converted into cash before the supplier has to be paid, which shrinks the amount of external funding the business needs. A retailer that turns stock over in 30 days but pays suppliers in 60 is being financed by its supply chain rather than by a bank.
For the seller, trade credit is a sales tool with a real cost attached. Every day of credit granted is a day of the seller's own cash tied up, and the seller carries the risk that the customer never pays at all, which is why credit checks and limits exist.
Many suppliers attach an early settlement discount, written as terms such as 2/10 net 40, meaning 2% off if paid within 10 days and the full amount due at day 40. Passing up that discount is expensive in annualised terms, because the buyer gives up 2% to gain only 30 extra days.
Trade credit is also fragile in a way bank funding is not. A supplier can cut terms overnight if it becomes nervous about a customer, and a business that has quietly built its whole working capital model on 60-day terms can find itself needing cash immediately when those terms drop to 30 days or to payment on delivery.
In practice
Real-world examples
Example 1
A garden centre buys $180,000 of spring stock on 90-day terms in February and sells most of it by May. The supplier's credit funds the entire season, so the business never touches its overdraft even though its own cash balance is thin in early spring.
Example 2
A print shop offers 2/10 net 30 to all commercial customers. Roughly 40% take the discount, which costs the shop 2% of that revenue but pulls forward enough cash to cover payroll without an invoice finance facility.
Example 3
A fast-growing meal kit company doubles order volumes and asks its packaging supplier for 60-day terms instead of 30. The supplier agrees but caps the credit limit at $120,000, which forces the company to spread purchasing across two suppliers to keep growing.
Think of it
Trade credit is like a tab at your local café. You enjoy your coffee and breakfast every morning, and instead of paying for each item on the spot, the barista lets you pay the total at the end of the month.
Formula
Calculation
The annualised cost of forgoing an early settlement discount is:
Cost = [Discount % / (100% - Discount %)] x [365 / (Full Term Days - Discount Days)]
A distributor is offered terms of 2/10 net 40 on a $200,000 monthly order. Paying at day 10 costs $196,000, since the 2% discount is $4,000. Paying at day 40 costs the full $200,000.
Step 1: Discount ratio = 2 / 98 = 0.0204
Step 2: Days gained = 40 - 10 = 30
Step 3: Periods per year = 365 / 30 = 12.17
Step 4: Cost = 0.0204 x 12.17 = 0.248, or 24.8% a year
Paying at day 40 rather than day 10 costs the distributor the equivalent of a 24.8% annual interest rate. If the company can borrow on an overdraft at 9%, it is better off drawing on the overdraft, taking the discount, and saving roughly 16 percentage points on that slice of spending.Case study
Seen in the real world
The following is a fictional illustration. Northgate Fixings, an invented industrial fastener wholesaler, had operated on 45-day supplier terms for years and treated them as free money. Its finance manager never modelled what would happen if those terms changed.
When a major supplier was acquired, the new owner standardised terms across the group at 21 days. Northgate suddenly needed roughly $340,000 of extra cash to bridge the 24-day gap, and the only facility available at short notice carried a 14% rate plus arrangement fees.
The lesson the fictional company took away was to treat trade credit as a funding line with a maturity, not as a permanent feature of the landscape. It began tracking its weighted average supplier terms every month and kept a committed overdraft equal to 30 days of purchases as a deliberate buffer.
Watch out
Common mistakes
- Believing trade credit is always free. It is free only within the agreed period and only where no early settlement discount is being sacrificed.
- Stretching payments beyond terms to improve cash flow. Late payment damages supplier relationships, can trigger credit limit cuts, and often ends with worse terms than the business started with.
- Granting credit to customers without checking them. A single unpaid $80,000 invoice can wipe out the margin on many months of profitable sales.
Questions
People also ask
Is trade credit shown as debt on the balance sheet?
It sits within trade payables as a current liability, not within borrowings, so it does not usually count towards bank covenant leverage tests.
How do suppliers decide how much credit to give?
They combine credit agency scores, filed accounts, payment history and trade references, then set a limit that caps their exposure to any one customer.
Should a business always take the early settlement discount?
Only when the annualised cost of forgoing it exceeds the company's own cost of borrowing, which for common terms such as 2/10 net 30 it almost always does.