Trade credit refers to the credit extended by the supplier of goods and services with the normal course of transaction business sale of the firm. According to trade practices, cash is not paid intermediately for purchases but after an agreed period of time. Thus, deferral of payment (trade credit) represents a source of finance for credit purchases.
There is, however, no formal specific negotiation for trade credit. It is an informal arrangement between the buyer and the seller. There are no legal instruments acknowledgements of debt which are granted on an open account basis. Such Credit appears in the records of the buyer of goods as sundry creditors accounts payable.
A variant of accounts payable is bills notes payable. Unlike the open account nature of accounts payable, bills notes payable represent documentary evidence of credit purchases and a formal acknowledgement of obligation to pay for credit purchases on a specified (maturity) date failing which legal penal action for recovery will follow. A notable feature of bills notes payable is that they can be rediscounted and the seller does not necessarily have to hold it till maturity to receive payment. However, it creates a legally enforceable obligation on the buyer of goods to pay on maturity whereas the accounts payable have more flexible payment obligations. Although most of the trade credit is on open account as accounts payable, the suppliers of goods do not extend credit indiscriminately. Their decision as well as the quantum is based on a consideration of factors such as earnings record over a period of time, liquidity position of the firm and past record of payment.