Trade Credit

Trade Credit is one of the most common, yet often overlooked, forms of financing in the business world. Think of it as a running tab. When a company buys goods or services from its suppliers, instead of paying cash immediately, the supplier gives them an invoice with a future due date—say, in 30 or 60 days. This arrangement is trade credit. Essentially, the supplier is giving the company a short-term, interest-free loan. It's the grease that keeps the wheels of commerce turning, allowing businesses to receive materials and sell their products before they have to pay for the raw ingredients. For businesses, it's a vital source of `working capital`, freeing up cash for other immediate needs like payroll or marketing. For suppliers, it’s a way to build strong customer relationships and encourage larger or more frequent orders, even though it means waiting to get paid.

The mechanics are straightforward and revolve around an invoice. When a supplier delivers goods, they issue an invoice detailing the amount owed and the payment terms. These terms are a crucial piece of the puzzle. You’ll often see shorthand like:

• `Net 30`: This means the full payment is due within 30 days of the invoice date.
• `2/10 Net 30`: This is a bit more interesting. It means the payment is due in 30 days, but if the buyer pays within 10 days, they get a 2% discount. For the buyer, taking this discount is often a fantastic, risk-free return on their cash. For the supplier, it’s an incentive to get their money back faster.

For a value investor, trade credit isn't just an operational detail; it's a story written on the `balance sheet`. It reveals clues about a company's power, efficiency, and financial health. Trade credit appears in two places, depending on whether the company is the buyer or the seller.

When a company receives goods on credit, the amount it owes to its suppliers is recorded as `Accounts Payable` (AP) in the liabilities section of its balance sheet. A large and growing AP balance can mean two very different things:

• A Sign of Strength: A company with a strong `moat` or significant buying power (like a Walmart or Amazon) can dictate favorable payment terms to its suppliers. It can essentially use its suppliers' money as a free loan to fund its operations. This shortens its `cash conversion cycle`, which is a fantastic sign of efficiency.
• A Red Flag: On the flip side, a ballooning AP could signal that the company is in financial distress and is unable to pay its bills on time. This is called stretching its payables. If revenues are falling while AP is rising, it's time to be cautious.

When a company sells its products to customers on credit, the money it is waiting to receive is recorded as `Accounts Receivable` (AR) in the assets section of its balance sheet. Again, this can be interpreted in two ways:

• A Competitive Tool: Offering generous credit terms can be a smart way to attract customers and boost sales, especially if competitors demand cash upfront. It shows the company is confident enough in its financial position to wait for payment.
• A Potential Risk: High or rapidly increasing AR can be a warning sign. It might mean the company is struggling to collect its dues, which could lead to `bad debt` (customers who never pay). It's crucial to check if AR is growing much faster than `revenue`. If it is, the company might be booking sales that it will never actually turn into cash—a classic accounting shenanigan.

Analyzing a company's use of trade credit is a core part of digging into its financial statements. It's about understanding the flow of cash and the power dynamics with suppliers and customers. Here’s what you should look at:

• Compare with Peers: How does the company's `Days Payable Outstanding (DPO)` (how long it takes to pay suppliers) and `Days Sales Outstanding (DSO)` (how long it takes to collect from customers) compare to its direct competitors? A company that pays its suppliers much slower and collects from its customers much faster than the industry average is often highly efficient and dominant.
• Watch the Trends: Are Accounts Payable and Accounts Receivable growing in line with sales? Sudden spikes or divergences are cause for investigation.
• Read the Fine Print: Check the company's annual report for any notes about its credit policies, customer concentrations, or allowances for doubtful accounts. This can provide context that the raw numbers don't.