The Firm must balance the advantages of trade credit against the cost of forgoing a possible cash discount, any possible late payment penalties, the opportunity cost associated with a possible deterioration in credit reputation and the possible increase in selling price the seller price imposes on the buyer. There are several advantages of trade credit as a form of short-term financing. Probably the major advantage is its ready availability. The accounting payable of most firms represent a continuous form of credit.
There is no need to formally arrange financing — it is already there. As old bills are paid and new credit purchases made, new accounts payable replace old, and the amount of trade credit financing fluctuates accordingly. If the firm is now taking cash discounts, additional credit is readily available by not paying existing accounts payable until the end of the net period. There is no need to negotiate with the supplier; the decision is entirely up to the firm. In stretching accounts payable, the firm will find it necessary, after a certain degree of postponement to negotiate with the supplier.
In most other types of short term financing, it is necessary to negotiate formally with the lender over the terms of a loan. The lender may impose restrictions on the firm and seek a secured position. Restrictions are possible with trade credit, but they not nearly as likely. With other sources of short term financing, there may be a lead time between the time the need for funds is recognized and the time the firm is able to borrow. Trade credit is a more flexible means of financing. The firm does not have to sign a note, pledge collateral, or adhere to a strict payment schedule on a note. A supplier views an occasional delinquent payment with a far less critical eye than does a banker or other lender.
The advantages of using trade credit must be weighted against the cost. As we have been, the cost may be high when all factors are considered. Many firms utilize other sources of short term financing to be able to take advantage of cash discounts. The savings in cost over other forms of short term financing, however, must offset the loss of flexibility and convenience associated with trade credit. For certain firms, there are no alternative sources of short term credit.
Trade credit involves a cost for the use of funds over time. This use is not free. The burden may fall on the supplier, the buyer, or both parties. The supplier may be able to pass the cost onto the buyer in the form of higher prices.
The supplier of a product for which demand may slow dramatically if prices are raised may be reluctant to increase prices. This supplier may, therefore, end up absorbing most of the cost of trade credit. Under other circumstances the supplier is able to pass the cost on to the buyer. The buyer should determine who is bearing the cost of trade credit. A buyer who is bearing the cost may shop around for a better deal. The buyer should recognize that the cost of trade credit changes over time. In periods of rising interest rates and tight money, suppliers may raise the price of their products to take account of the rising of carrying receivables. This rise in price should not be confused with other rises caused by changing supply and demand conditions in the product markets.