Understanding Trade Credit for Small Businesses
Trade credit allows businesses to receive goods or services in exchange for a promise to pay the supplier within a set amount of time. New businesses often have trouble securing financing from traditional lenders; buying inventory, for example, on trade credit helps increase their purchasing power. Suppliers who agree to invoice customers may benefit from larger contracts and new partnerships.
A startup’s short credit history rarely offers enough reassurances to satisfy the stricter lending standards of banks and major financial institutions. Many new companies have worked within these constraints by applying for trade credit from vendors. These business-to-business arrangements can offer advantages and drawbacks for both the customer and supplier. When used successfully, trade credit can help companies get on their feet and establish business credit. In exchange, suppliers may earn new business – and loyalty – from startup customers.
Buying on Trade Credit
There are several possible benefits to purchasing goods or services on a trade credit account. As previously mentioned, many suppliers will extend trade credit to businesses that appear too risky for traditional lenders to finance. Trade credit is usually offered without interest charges, so long as the client pays their balance on time. The most common payment term is known as net 30, or paying within 30 days of purchase or invoice. Some suppliers want to build new business relationships that will lead to further purchases and will take on the risk associated with a new business.
Merchants who can defer payment may be able to sell products before the balance is due, reducing their own capital outflow. Many suppliers offer discounts for early repayment, which is something a third-party, like a bank, probably couldn’t control.
Finally, suppliers who report positive payment experiences to business credit bureaus may help build a business’s credit scores and ratings. These instances of reporting are known as trade references, and are one of the factors many business credit bureaus may consider when evaluating a company’s financial reliability.
What are some downsides of acquiring goods or services on trade credit? Failure to pay on time can bring costly late fees and interest charges. Delinquent accounts may also sour business relationships and negatively affect a company’s reputation, so it’s imperative to keep obligations in line with the ability to pay.
Extending Trade Credit
There are plenty of ways that offering trade credit to businesses benefits established suppliers. Customers who do not have to pay the full price of goods or services up front may be less cost-averse. This can lead to more lucrative sales and might help suppliers increase their profit margins.
Extending credit can also improve customer relations. A supplier who takes a risk on a new company may earn its loyalty, making trade credit a possible tool for business development. Businesses start small, but successful partners may increase their purchase orders down the road. In the best-case scenario, a relatively small risk can pay off with substantial, long-term benefits.
Business credit bureaus like Dun & Bradstreet can run a business credit check to help you gain an accurate picture of the creditworthiness of a potential borrower. Credit reports also offer a maximum credit recommendation that suggest an appropriate limit. Not many companies offer open credit terms to new customers, and setting credit limits is an important part of credit risk management. If a business is too new and hasn’t yet established any business credit scores and ratings, consumer credit bureaus may be able to provide insights into the owner’s financial history.
Having as much information as possible can make it easier to set the payment terms of a trade credit agreement.
Cost of Trade Credit
While buying and extending trade credit has much to recommend it, it is not without potential pitfalls: businesses that offer trade credit run the risk that customers will fail to repay them on time and in terms. They then find themselves in the unfortunate position of having to collect the debts, which impacts monthly cash flow. A supplier may be able to purchase trade credit insurance to guard against some of this risk. Just as customers shouldn’t overestimate their ability to pay, it’s important for lenders to keep their potential losses manageable.
Companies that extend trade credit have a credit policy that defines their terms. Whether you’re receiving or extending trade credit, understanding the terms of the agreement is crucial. Many companies offer early payment discounts, and customers that have the available cash flow should ask for them. A common discount is 2/10 net 30 (also written as 2/10/30), whereby a 2% discount can be claimed when paying within 10 days of invoicing, and that the balance must be paid no later than 30 days after the invoice is issued.
Let’s show how this is a smart calculation for the cost of trade credit, from an accounts payable standpoint. If you ordered $5,000 worth of inventory and secured a 2/10 net 30 discount, then you would save $100 if you paid by the 10th day. If you ordered $5,000 worth of merchandise every month on 2/10 net 30, you would increase your company’s cash flow by $1,200 per year.
Trade Credit Management
Unlike other types of credit, trade credit financing is restricted to businesses, relatively short-term, usually unsecured, and can offer discounts for early payments. Since it doesn’t usually require collateral, trade credit can provide a much more accessible form of financing than bank loans, credit cards, and lines of credit. Companies that extend credit employ credit managers to oversee this function, which is part of accounts receivable. Credit managers are responsible for evaluating new and recurring applicants and assessing them for creditworthiness, and managing business credit risk for all of the company’s customer accounts. Many of them are also responsible for collections should their customers fail to pay on time.
Trade credit has helped many companies increase their purchasing power and develop new relationships. As with all important business decisions, consider consulting with a financial expert or attorney before opening or offering a trade credit account.