Understanding The Trade Credit Advantages And Disadvantages with Research
So Until the year 2015 trade credit has been growing in India, but post 2015 there was a sharp decline of 24%.Another important insight is that trade credit which was growing at 16% pre 2015, has dropped to 4%. In this small research article I will discuss the Trade credit advantages and disadvantages, and the reasons for the change in trend.
How Does Trade Credit Work
The basic structure of trade credit, is that the seller provides an informal facility of delaying the actual cash payment to the buyer.
It should be interesting to note that there are three major players and relationships working here;
- Seller offering trade credit to the buyer
- The seller demanding credit to the supplier
- And the supplier demanding credit to the manufacturer
Now usually, the average trade credit period is around 30 days without no cost. However, these credit terms can actually lead to expensive payment terms.
Advantages of Trade Credit
So let me quickly list of the benefits of trade credit below;
- It definitely relieves the pressure on working capital. Which means the company has improved cash flow.
- Secondly it’s cheaper. Especially when compared to short term financing options, this method is hassle free.
- Thirdly, it’s off the books. No interest expense will be seen in the financial statements.
- Doesn’t require formal application or collateral and even credit ratings.
- Trade credit agreement stands as the 2nd biggest source of short term financing
- Trade credit enhances cross border transaction which is done through banking channels.
- During tight monetary situations, the companies can continue capex for business growth using trade credit to offset working capital needs.
- Another issue is that trade credit agreements will only be done in situations where the transactions are frequent. Elese there would be no cost reduction for both the parties.
- Higher access to information to check credit worthiness, as the supplier has the ability to visit the premises of the company.
- Trade credit has a higher recovery rate at around 95.2%, especially in case of export finance.
Trade Credit Fall in 2018 in India
As mentioned above I said that trade credit terms got tightened for foreign banks in India. As a result of which overall trade credit dropped. Let me show you this has affected also the big listed companies in India.
Below I have shown the days of payable for the top 3-4 listed companies in India. And there is a clear fall from 2017 onwards. In fact the trade credit overall doesn’t seem to have come over the pre 2017 levels.
Disadvantages of Trade Credit
Now let me take you through some major issues with delaying payments structure.
- Smaller firms usually cannot demand credit, and even alternate source of financing might be limited.
- Secondly in situations where the monetary conditions are rough. The the supplier of trade credit, has the ability to command lower discounting.
- Trade credit can become more expensive than traditional financing, if early payments discount is not used.
- Another interesting issue is that use of trade credit can lead to wrong conclusions on solvency.
- Generates business flexibility with more types of trade credit. For example a net 15 or 30 system, where the payments need to be done within due date. Or a discount system where the credit offers certain discount on early payments.
- Suppliers can use good credit terms to attract more customers. This can especially be true with FMCG distribution companies.
Trade Credit Insurance
Ensuring that bad debts don’t affect negatively the balance sheet of a supplier company, credit insurance has become popular. Let me briefly discuss the scope of coverage;
- Helps in information screening of clients
- Protects the balance sheet
- Provides collection services
- Helps in mitigating cash flow problems.
- This also helps in covering political risks
Now trade credit insurance is actually available across three segments which is. Firstly credit insurance for domestic, for purchase of goods or services related to exports .
Some of the banks which offer credit insurance are; SBI general insurance, HDFC ergo, Atradius. Below are some insights to the comparison of trade credit market across the globe.
Cost of Credit Insurance
Generally the insurance companies would charge basis the percentage of sales or accounts receivables. For a ball park calculation, the approximate cost would be around $5000 for a total $2mn in revenue.
Overall the trade credit insurance is a $92 Bn market and is growing at a CAGR Of 12%.
Below I have shown the overall market share of credit insurance industry.
Business Growth & Trade Credit Correlation
The correlation between trade credit growth rate and business growth rate in the provided data is approximately 0.91. This indicates a very strong positive correlation, suggesting that as trade credit availability increases, business growth tends to increase significantly as well.
This strong correlation implies that in the Indian context, trade credit plays a crucial role in supporting business growth. Firms likely rely on trade credit as a key source of working capital, which enables them to maintain operations and invest in growth opportunities, even in periods when other forms of credit might be less accessible or more expensive.
Sectoral Differences
Different business’s have different dependencies on trade credit. For example; the sector with lowest trade credit is agriculture, while the highest is seen in mining. And this should make sense intuitively, because the seller in case of mining has to maintain a certain level of production relative to the demand.
Below chart using the RBI data, shows the amount of loan given by various kinds of banks related to trade finance. And it’s pretty clear that foreign banks still own a huge chunk. Majorly due to their presence across various countries.
Conclusion on Trade Credit Advantages and Disadvantages
At the end of this discussion, you might be promoted to question. Is trade credit good or bad? The short answer is that there is no question that trade credit infrastructure is required. Especially for the core industries, which have multi country exposure. At the same time, there needs to more developments in the trade insurance products side parlallely to ensure higher adoption rate. This is also true in case of India furthermore, because of the implementation of GST.
Since the implementation of GST, the GST cycle has already created pressure on working capital. And if trade credit are not reformed, then this will lead to negative impact to SME industries. Since SME industries won’t have the credit backing for a regular financing for loan anyways. And the major contribution for the growth of an economy has to come from new business’s.
