Trade Credit

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Definition of 'Trade Credit'

Trade credit is a form of credit that is extended by one company to another company for the purchase of goods or services. It is an important part of the working capital of many businesses, as it allows them to purchase goods and services without having to pay for them immediately. Trade credit can be extended in a variety of ways, including open account, documentary collections, and letters of credit.

**Open account** is the most common form of trade credit. In an open account arrangement, the seller extends credit to the buyer by allowing them to pay for the goods or services at a later date. The buyer is typically given a certain amount of time to pay, such as 30 days or 60 days.

**Documentary collections** are used when the seller wants to ensure that they will be paid for the goods or services that they have shipped. In a documentary collection arrangement, the seller sends the shipping documents to the buyer's bank. The bank then presents the documents to the buyer, who must pay for the goods or services before they can be released.

**Letters of credit** are a more secure form of trade credit than open account or documentary collections. In a letter of credit arrangement, the buyer's bank issues a letter to the seller guaranteeing that the buyer will pay for the goods or services. This gives the seller the assurance that they will be paid, even if the buyer defaults.

Trade credit can be a valuable source of financing for businesses, but it is important to manage it carefully. Businesses that extend trade credit should carefully assess the creditworthiness of their customers and should have a clear policy for collecting payments. Businesses that receive trade credit should also carefully review the terms of the agreement and make sure that they are able to meet the payment terms.

Trade credit can be a complex topic, but it is an important one for businesses to understand. By understanding the different types of trade credit and how they work, businesses can make informed decisions about how to use trade credit to their advantage.

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