Trade Credit Guide

Trade Credit Guide

Trade credit is a business-to-business arrangement where a seller delivers goods or services now and allows the buyer to pay later, typically in 30, 60, or 90 days. It essentially functions as an interest-free short-term loan from the supplier to the buyer. In practice, trade credit is extremely common – it remains the single largest source of short-term business credit in the U.S. and worldwide. Payment terms like Net 30 or Net 60 define the due date for payment, and suppliers may offer early-payment discounts (for example, 2%/10 Net 30 means a 2% discount if paid in 10 days) to incentivize quicker payment. Conversely, contracts can include late payment fees, retention clauses (withholding a portion of payment until certain conditions are met), and setoff rights (allowing deductions for claims or returns) that affect the final amount. Importantly, the credit risk – the chance of non-payment – rests with whoever ultimately waits for the cash on the due date. On open account terms the supplier bears the risk of buyer default unless that risk is transferred via a “wrapper” like credit insurance or a bank guarantee. The goal for both parties is simple: protect cash flow, ship and receive goods on time, and ultimately collect payment in full without surprises.

Snapshot: Standard trade credit terms typically span 30 to 120 days. “Open account” (ship now, pay later) is used for about 80% of international trade transactions, especially with established buyers, because it’s simple and low-cost for the buyer. Higher-risk trade relationships tend to utilize more secure instruments like documentary collections, guarantees, or letters of credit for assurance. Suppliers can offload credit risk by using trade credit insurance or getting a bank to confirm (guarantee) payment obligations. An early-payment discount of 2/10 Net 30 carries an implied annual interest cost of roughly 36.7% – far higher than most borrowing costs – so buyers should compare discount terms to their own cost of capital. Effective programs require clear policies and controls around credit approval, proof of delivery, and timely resolution of any payment disputes. See our How It Works and Procedure for next steps.

What Buyers and Suppliers Gain

For Buyers

  • Stretch payables to align outflows with inventory sell-through and seasonal cash cycles.
  • Secure a steady supply of goods without immediately drawing on bank credit lines.
  • Capture early-payment discounts when cash is available at low opportunity cost.
  • Negotiate better pricing or volume rebates by committing to larger orders on credit.

For Suppliers

  • Boost sales by offering attractive payment terms to buyers (a competitive differentiator).
  • Transfer or mitigate credit risk on receivables via trade credit insurance or bank confirmations.
  • Convert accounts receivable into immediate cash through factoring or payables finance programs.
  • Enforce tight invoicing and dispute deadlines to reduce revenue dilution from returns or chargebacks.

Core Mechanics

Step What Happens Controls
Purchase Order & Terms Buyer issues a purchase order. The agreed payment terms are set (e.g. Net X days, any early-pay discount like 1% 10 days, late interest penalties, retention amounts, relevant Incoterms for delivery). Pre-approve buyer credit up to a limit; obtain signed T&Cs covering payment and dispute terms; perform KYC and sanctions checks on new buyers.
Shipment & Evidence Goods are shipped or services rendered. Delivery is documented via signed proof of delivery, goods receipt note, or completion certificate per contract. Require valid proof of delivery (POD) or goods receipt (GRN); link transport documents or completion sign-offs to the order; use inspection reports for quality where relevant.
Invoice Approval Supplier issues an invoice. It is logged in the buyer’s ERP, matched against the PO and delivery documents, then approved for payment scheduling. Ensure an immutable audit trail of invoice approval; implement 3-way matching (PO, receipt, invoice); segregate duties so no single person controls the entire payables process.
Early Payment or Due Date If the supplier needs cash, they may take an early-pay discount or sell the receivable to a financier. Otherwise, the buyer pays the full amount on the due date (Net X). Define clear discount terms and cut-off dates in the contract; maintain a single source of truth for outstanding balances, adjustments, or any set-offs applied.
Collections & Disputes If the due date passes without payment, the supplier initiates collection efforts. Any invoice disputes must be raised by the buyer within a defined window (e.g. 10 days from receipt) or else the invoice is deemed accepted. Keep dispute notification windows short; require specific reason codes and evidence for any deductions; maintain an audit trail of all communications and approvals for write-offs or adjustments.

Common Instruments

Open Account

Goods are shipped and delivered before payment is due – typically 30, 60, or 90 days later. This is the cheapest and simplest method for the buyer, but it leaves the supplier taking on full unsecured credit risk unless mitigated by other means.

Documentary Collection (URC 522)

The supplier ships goods and entrusts its bank to forward shipping documents to the buyer’s bank, which releases them to the buyer only against payment (D/P) or acceptance of a draft (D/A). Banks act as intermediaries to exchange documents for payment but provide no guarantee – if the buyer fails to pay at maturity, the recourse is simply return of unpaid documents. This is useful for moderate-risk trades where using a full letter of credit is unwarranted.

Letter of Credit (UCP 600)

A letter of credit (LC) is a commitment by the buyer’s bank to pay the supplier once specified documents (e.g. bill of lading, invoice, etc.) are presented in compliance with the LC terms. It’s one of the most secure instruments for international trade – the issuing bank effectively substitutes its credit for the buyer’s, guaranteeing payment if all conditions are met. LCs can also be confirmed by a second bank (typically the supplier’s local bank), adding another guarantee to eliminate foreign bank and country risk for the supplier.

Guarantees & SBLCs (URDG 758 / ISP98)

These are on-demand undertakings by a bank (or surety) to pay if the buyer or supplier fails to perform or pay as agreed. A standby letter of credit (SBLC) functions as an “insurance policy” on an open-account trade: the buyer’s bank promises to pay the supplier on demand if the buyer doesn’t pay on time. Similarly, a demand guarantee (governed by URDG 758) can back performance or payment obligations, where the guarantor pays upon presentation of a simple demand and any required statement of default. In short, these instruments transfer the default risk to a bank: the bank pays the beneficiary upon a complying demand, then seeks reimbursement from the applicant.

Credit Insurance

A trade credit insurance policy indemnifies the supplier against a large portion of an invoice if the buyer doesn’t pay due to insolvency, protracted default, or political events. Typically the insurer will cover 75%–95% of the outstanding amount after a waiting period, up to a credit limit. This protects the supplier’s receivables and can enable non-recourse financing (because banks or factors can be named as loss payees or beneficiaries of the policy). Credit insurance thus shifts most of the credit risk onto the insurer, minus any deductible or uninsured percentage.

Confirmations

In trade finance, a “confirmation” usually refers to a bank (often in the supplier’s country) adding its promise to pay on an instrument issued by a foreign bank or buyer. For example, a confirming bank may guarantee an LC or SBLC, thereby removing the exporting supplier’s exposure to the foreign issuing bank or sovereign risk. Similarly, in some supply-chain finance programs a bank might confirm (purchase) approved payables from a strong buyer, letting the supplier get paid without holding the buyer’s credit risk. In all cases, confirmations allow exporters to rely on the credit of a highly rated confirming bank instead of the underlying counterparty.

Pricing and Math

Offering early-payment discounts has an implicit cost of capital. It’s often much higher than it looks. A standard formula to annualize an early-pay discount is: (d / (1 − d)) × (360 / (N − T)), where d is the discount rate (in decimal), T is the discount deadline in days, and N is the net term (full due days). This formula computes the effective annual interest rate a buyer earns (and equivalently the supplier pays) by taking the discount. For example, under 2/10 Net 30, plugging d = 0.02, T = 10, N = 30 gives roughly 36.7% annualized. In other words, a 2% discount for paying 20 days early equates to a ~36.7% annual interest rate cost to the supplier (and benefit to the buyer). By the same token, 1/10 Net 30 works out to about 18.2% annualized. Even a seemingly generous 3/10 Net 60(3% for paying 50 days early) is ~22.3% annual. These rates far exceed typical bank financing costs. Suppliers should view early payment discounts as price concessions against margin (albeit with the benefit of getting cash sooner and potentially reducing credit risk), and buyers should compare the implied return to their own cost of capital or alternative uses of cash.

Offer Implied Annual Rate Comment
2/10 Net 30 ~36.7% Makes sense for buyer if their cash can earn above this rate, or if taking the discount meaningfully lowers default risk exposure.
1/10 Net 30 ~18.2% Often cheaper than a small buyer’s cost of unsecured borrowing – attractive for buyer, costly for supplier.
3/10 Net 60 ~22.3% Longer baseline (60 days) dilutes the annualized cost despite the higher headline discount.

From the supplier’s perspective, any discount given comes straight out of gross profit (though it might save on potential bad-debt loss or financing cost if cash is tight). From the buyer’s perspective, early-pay discounts offer a risk-free return on idle cash – but if the buyer’s own weighted average cost of capital (WACC) or short-term borrowing rate is lower than the implied discount rate, it may be cheaper to pay on normal terms and invest or use the cash elsewhere.

Risk and Controls

  • Counterparty risk: The fundamental risk that the buyer will fail to pay on time (or at all). Mitigation includes setting credit limits per buyer, requiring upfront payment from high-risk buyers, obtaining third-party support (like an LC or guarantee from a bank), or insuring the receivables.
  • Dilution risk: The risk that the invoice value is reduced for reasons other than non-payment. Common causes include returns, volume rebates, pricing disputes, short shipments, or other credits issued to the buyer. Controls to limit dilution include tight contract terms (e.g. no unilateral deductions after a certain date), short windows for claims/returns, and tracking of credit notes with management oversight.
  • Documentation risk: Weak or missing documentation can lead to non-payment or disputes that the supplier loses. Use clear written contracts defining what documents evidence delivery and acceptance, ensure every shipment has signed delivery docs, and keep meticulous records. For documentary instruments, strict compliance with terms is critical.
  • Country and FX risk: Cross-border trade introduces foreign exchange controls and political risks. Currency swings can also erode margins. Mitigate with confirmed instruments, hard-currency invoicing or hedging, and consider ECA/political risk insurance where appropriate.
  • Fraud and identity risk: Threats include fake purchase orders, “invoice hijacking,” and impersonation. Apply stringent onboarding, verify payment-instruction changes via call-back, enforce dual approvals for high-value payments, and monitor red flags such as unusual order patterns or mismatched ship-to addresses.

Worked Example in USD

Consider a supplier that has issued a $10,000,000 invoice on Net 60 payment terms (60 days credit). The buyer’s terms include an optional early payment discount of 1.5% if paid within 10 days ( 1.5/10 Net 60 ). The supplier is evaluating two options:

  • Option A: Take the 1.5% early-pay discount by Day 10. The buyer deducts 1.5% ($150,000) and pays by day 10. The supplier receives $9,850,000 early. The implied annual cost of this discount is about 10.96% (1.5% cost over 50 days annualized). Credit risk is eliminated quickly because cash is received on day 10.
  • Option B: Keep the full $10,000,000 invoice and sell (factor) the receivable to a financier at a 5.0% annual rate on a without-recourse basis. If sold immediately, for the 50 days remaining the financing cost is roughly $69,444(5% prorated), so the advance is approximately $9,930,556. The financier collects $10,000,000 at day 60.
  • Difference: Option B yields about $80,556 more cash than Option A while achieving early liquidity and transferring buyer credit risk to the factor (assuming true non-recourse).

Accounting and Working Capital

  • Suppliers (Accounts Receivable): Until payment is received (or invoices are factored), the receivable remains on balance sheet. Longer terms increase DSO and tie up working capital. True non-recourse sales can derecognize receivables and reduce DSO, but discounts/fees reduce margin.
  • Buyers (Accounts Payable): Trade credit appears as AP until paid. Extending terms raises DPO and supports operating cash flow, but pushing too far strains suppliers. Some structured payables programs can affect classification; follow applicable standards and disclosure rules.
  • Cash Conversion Cycle (CCC): CCC = DSO + DIO – DPO. Granting credit raises DSO (longer to collect). Taking credit raises DPO (longer to pay). Optimizing CCC means faster collections, faster inventory turns, and sensible payables extension without damaging supply reliability.

When to Use What

Scenario Preferred Route Why
Repeat buyer, low disputes, trusted relationship Open account with an appropriate credit limit (optionally insured for large exposures) Keeps costs low and shipping fast. Standard approach for established, low-risk relationships.
New customer or higher-risk country/sector Letter of Credit (LC) – ideally confirmed by a reputable bank, or a standby LC / guarantee Shifts payment risk to the issuing/confirming bank and addresses bank/sovereign risk.
Large portfolio of buyers, diverse and growing Credit insurance + Receivables finance(factoring/securitization) Covers defaults across many buyers and enables scalable, often non-recourse liquidity.
Document-heavy transaction (e.g. ocean freight with title documents) Documentary collection(D/P or D/A) Provides document control via banks without the full cost/complexity of an LC when default risk is moderate.

Eligibility and Data Room Checklist

Item Details
Buyer Master File Profile each buyer: credit limit, latest financials/credit score, country risk rating, and compliance checks (sanctions, AML, PEPs).
Payment Terms & T&Cs Standard terms covering Net X, discount windows, late fees, setoff permissions, retention, and governing law/jurisdiction. Signed acceptance preferred.
Evidence of Delivery POD/GRN, inspection certificates, acceptance certificates, mapped to Incoterms to show risk/title transfer points.
ERP Approval Data Invoice creation/approval dates, approvers, reversals/credit notes, and dispute logs. Required for financing/insurance due diligence.
Policies or Instrument Copies Credit insurance policy terms/limits and consent-to-assign, LC/guarantee templates, and any document affecting collectability/transferability.

Frequently Asked Questions

Is trade credit a loan?
Not in the traditional sense. Trade credit is a payment term extended by a supplier, not a cash loan from a bank. It allows the buyer to pay later without interest, functioning like a 0% short-term loan recorded as accounts payable. If the supplier finances those receivables (borrowing against them or selling them), that is a separate transaction that may be recourse or true-sale non-recourse.
Who bears risk on open account?
The supplier bears the risk until paid because delivery precedes payment. Risk can be transferred via credit insurance, non-recourse factoring, or bank instruments (LCs/SBLCs/guarantees).
What rules govern documentary instruments?
ICC rules apply: UCP 600 for commercial letters of credit, URDG 758 for demand guarantees, ISP98 for standby LCs, and URC 522 for collections. Incoterms 2020 define delivery and risk transfer terms (e.g., FOB, CIF).
How do early-payment programs fit in?
Buyer-led payables finance lets suppliers get paid early at a rate tied to the buyer’s credit profile, with the buyer paying the financier at maturity. Dynamic discounting uses the buyer’s own cash on a sliding discount scale. Both improve supplier liquidity and can reduce risk versus static discounts.

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Every business has unique buyers, terms, and challenges. If you’re looking to optimize your trade credit strategy, manage risks, or arrange financing, we can help. Share your buyer profiles, current payment terms, dispute rates, and sample documents. We will analyze them and map out the right set of instruments, provide pricing benchmarks, and recommend a control framework tailored to your needs.

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Disclaimer: Financely acts as an advisor and arranges capacity through regulated partners. We do not custody client funds. All engagements are subject to underwriting, KYC, AML, and sanctions screening, as well as legal review and final approval by funding counterparties and insurers. ICC rules referenced include UCP 600, URDG 758, ISP98, and URC 522. This information is intended for professional clients and eligible counterparties only.

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