Why Companies Offer Trade Credit

small business

Trade credit, or financing provided by the seller of a product, is an common way that small companies borrow, with research showing that 60 percent of small companies make use of it. Typically, companies receive trade credit by declining a seller’s discount for faster payment. By taking more time to pay, buyers are, in effect, getting a short term loan.

Explaining why companies use trade credit is relatively easy. It’s a substitute for more expensive and more-difficult-to-obtain forms of credit, such as bank loans, academic studies show. When banks make credit more difficult to obtain, or when companies are young or faltering and cannot easily borrow money from other sources, their owners often turn to trade credit as a source of capital.

But why do sellers offer trade credit to their customers? Some researchers argue that companies provide trade credit because they have access to lower cost financing than other firms. However, other studies showthat firms in worse financial condition supply more trade credit than those in better financial condition, and firms with greater access to credit themselves provide less trade credit than those with lesser access to capital, suggesting that something other else must be at play.

The most compelling explanation is that trade credit is a sales tool. Scholarly investigations indicate that sellers use trade credit to signal to customers that they are offering high quality products. In addition, sellers of more unique products and services offer more trade credit at a cheaper price and with less concern for the creditworthiness of the buyer than sellers of commodity-like goods and services, studies show. Finally, companies that face more competition to sell their products and services are more likely to provide trade credit to their customers than those in less competitive markets, research reveals.

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.