Understanding Different Types of Trade Credit Terms

Trade credit is an arrangement between a buyer and a seller where the buyer receives goods or services now and agrees to pay for them later, according to agreed-upon payment terms. Trade credit is essential for businesses because it allows them to manage cash flow more effectively, avoid upfront payments, and potentially take advantage of early payment discounts. Suppliers often extend trade credit to build long-term customer relationships, encourage repeat business, and enhance sales volume.

This article explores the different types of trade credit terms, their structures, and how they impact business transactions. Understanding these terms can help businesses make informed decisions on when and how to make payments and optimize their cash flow.

Types of Trade Credit Terms

Trade credit terms can vary significantly depending on the industry, the relationship between the buyer and supplier, and the buyer’s creditworthiness. Here are the primary types of trade credit terms:

1. Net Terms (e.g., Net 30, Net 60)
2. 2/10 Net 30 (Early Payment Discount)
3. Consignment Terms
4. Installment Credit
5. Seasonal Dating Terms
6. Cash Before Delivery (CBD) and Cash on Delivery (COD)

Each type of trade credit term has distinct advantages and structures that cater to various business needs. Let’s dive into each type, discussing how they work and including examples to illustrate their usage.

1. Net Terms (e.g., Net 30, Net 60)

Net terms are among the most common forms of trade credit. In a net-term arrangement, the buyer is required to pay the full invoice amount by a specified date after receiving the goods or services. Common net terms include Net 30, Net 45, and Net 60, where the numbers represent the number of days within which payment is due. For example, in a Net 30 term, the buyer has 30 days from the invoice date to make the payment.

How Net Terms Work

• Invoice Date: The supplier issues an invoice with the goods, marking the start of the credit period.
• Payment Due Date: The buyer must pay the full amount by the end of the agreed-upon period (e.g., 30 days for Net 30).
• No Discounts: Typically, net terms do not include early payment discounts.

Example: Net 30 Trade Credit

A retail store receives inventory from a supplier with a Net 30 term. The invoice is dated January 1, and the store has until January 31 to pay the supplier in full. This arrangement allows the store to generate revenue from sales before making the payment, improving cash flow.

Pros and Cons of Net Terms

• Pros: Allows buyers to manage cash flow, reduces the need for immediate capital, and offers predictable payment dates.
• Cons: May not incentivize early payment, and longer terms may expose suppliers to delayed cash inflows.

2. 2/10 Net 30 (Early Payment Discount)

2/10 Net 30 is a type of trade credit term that incentivizes early payment by offering a discount if the invoice is paid within a specified period. In the 2/10 Net 30 term, the buyer can take a 2% discount if payment is made within 10 days. If the buyer does not take advantage of the discount, the full invoice amount is due in 30 days.

How 2/10 Net 30 Terms Work

• Discount Period: The buyer receives a discount if payment is made within the first 10 days.
• Full Payment Period: If the buyer doesn’t pay within the discount period, the full payment is due by the end of 30 days.
• Encourages Early Payment: The discount incentivizes the buyer to pay early, improving the supplier’s cash flow.

Example: 2/10 Net 30 Trade Credit

A restaurant supplier offers a 2/10 Net 30 term on a $10,000 invoice to a client. If the restaurant pays within 10 days, it only pays $9,800 (a $200 discount). If it waits until the end of the 30 days, it owes the full $10,000. This discount helps the restaurant save money, and the supplier benefits from receiving payment sooner.

Pros and Cons of 2/10 Net 30 Terms

• Pros: Improves supplier cash flow, encourages early payment, and provides buyers with cost savings.
• Cons: Buyers may not always have funds for early payment, and suppliers may forgo a portion of revenue through the discount.

3. Consignment Terms

Under consignment terms, the supplier allows the buyer to stock and sell goods but only requires payment once the goods are sold. The goods remain the property of the supplier until sold by the buyer. Consignment terms are particularly popular in industries with variable demand, such as retail, where unsold inventory can be a financial burden.

How Consignment Terms Work

• Goods Ownership: The supplier retains ownership until the buyer sells the goods.
• Payment on Sale: The buyer pays the supplier only after the goods have been sold.
• Inventory Flexibility: The buyer can return unsold items, reducing inventory risk.

Example: Apparel Retailer on Consignment

A clothing brand provides a boutique store with products on consignment terms. The store does not pay upfront but rather only pays the brand after it sells each item. If certain items do not sell, the boutique can return them, allowing the brand to distribute inventory risk and enabling the boutique to offer a larger selection without initial capital.

Pros and Cons of Consignment Terms

• Pros: Reduces inventory risk for buyers, allows flexibility in stock management, and enables suppliers to reach new markets.
• Cons: Delays cash inflow for suppliers and requires trust and inventory tracking from both parties.

4. Installment Credit

Installment credit terms allow buyers to pay for goods over multiple scheduled payments rather than paying the full invoice amount upfront or within a short period. This type of trade credit is especially useful for expensive or capital-intensive items, as it spreads the payment burden over several months or years.

How Installment Credit Works

• Down Payment: An initial payment is often required, with the remaining balance divided into installments.
• Scheduled Payments: Buyers make regular payments until the total amount is paid off, usually including interest.
• Ownership Transfer: Ownership of goods may transfer immediately or after the final payment, depending on the agreement.

Example: Manufacturing Equipment on Installment Credit

A factory purchases a new piece of equipment from a supplier on installment credit. The total price is $100,000, with a $20,000 down payment and monthly installments of $5,000 for the remaining $80,000. This arrangement enables the factory to use the equipment immediately while spreading out the payments.

Pros and Cons of Installment Credit

• Pros: Allows buyers to acquire expensive assets without immediate full payment, supports cash flow management, and enables asset utilization.
• Cons: May include interest charges, increases buyer debt, and delays full payment for suppliers.

5. Seasonal Dating Terms

Seasonal dating terms are tailored to businesses with seasonal revenue cycles, allowing buyers to receive goods ahead of peak sales periods and pay after sales are made. This arrangement is common in industries like retail and agriculture, where sales are concentrated in certain seasons, helping businesses optimize cash flow.

How Seasonal Dating Terms Work

• Delayed Payment Due Date: Payment is due after the buyer’s peak season, allowing the buyer to generate sales before paying the supplier.
• Interest-Free Period: Typically, there is no interest charged on the delayed payment.
• Supports Seasonality: Allows buyers to receive stock in advance of sales without immediate payment.

Example: Retailers Preparing for Holiday Season

A toy manufacturer supplies a retailer with inventory in September, with payment due in January, after the holiday season. This arrangement allows the retailer to stock up in advance, generate holiday sales, and use the revenue to pay the manufacturer without straining cash flow before the season.

Pros and Cons of Seasonal Dating Terms

• Pros: Helps seasonal businesses manage cash flow, encourages large orders, and strengthens supplier-buyer relationships.
• Cons: Delays payment for suppliers, increases risk if seasonal sales do not meet expectations, and requires supplier trust in buyer demand forecasting.

6. Cash Before Delivery (CBD) and Cash on Delivery (COD)

Cash Before Delivery (CBD) and Cash on Delivery (COD) terms are payment arrangements requiring buyers to make payments at different points of delivery. CBD requires full payment before goods are shipped, while COD allows buyers to pay upon receiving the goods. These terms are often used when a buyer’s creditworthiness is uncertain or for first-time transactions.

How CBD and COD Terms Work

• Cash Before Delivery (CBD): The buyer pays in full before the supplier ships the goods, minimizing risk for the supplier.
• Cash on Delivery (COD): The buyer pays upon receiving the goods, providing assurance that goods arrive before payment is made.
• Risk Mitigation: Both terms mitigate the supplier’s risk of non-payment.

Example: CBD for a New International Client

A furniture manufacturer receives an order from a new international retailer. Due to the lack of credit history, the manufacturer requires full payment (CBD) before shipping the goods. This arrangement protects the manufacturer from potential non-payment issues.

Pros and Cons of CBD and COD Terms

• Pros: Minimizes risk of non-payment, provides immediate cash inflow for the supplier, and suitable for new or high-risk buyers.
• Cons: Restricts cash flow for buyers, potentially discourages large orders, and can deter new customers.

Choosing the Right Trade Credit Terms

The appropriate trade credit terms depend on factors such as:

• Industry Norms: Some industries favor certain terms, like consignment in retail or Net 30 in B2B.
• Cash Flow Needs: Seasonal businesses may prefer seasonal dating, while capital-intensive companies may need installment credit.
• Creditworthiness: Buyers with strong credit histories may qualify for longer net terms, while CBD or COD is safer for higher-risk buyers.
• Relationship Quality: Established supplier-buyer relationships often lead to more favorable terms, such as early payment discounts or extended credit.

Conclusion

Trade credit terms are integral to fostering strong business relationships, supporting cash flow, and managing financial risk. From common Net 30 terms to specialized options like seasonal dating and installment credit, each type of trade credit term offers unique benefits and potential challenges for buyers and suppliers. By understanding the various types of trade credit terms, businesses can choose the most advantageous arrangements for their specific needs, leading to better cash flow management, stronger supplier partnerships, and a competitive edge in the marketplace.