Trade credit allows your company to buy goods and services — without having to pay upfront.
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What is trade credit?
Trade credit is a business-to-business (B2B) financing agreement, where buyers can purchase goods on “credit” i.e. without paying upfront. More simply, trade credit operates on a “buy now, pay later” model.
Trade credit can be valuable for small businesses and startups, who often can’t easily get the funds required to operate and grow. Firms that are eligible for trade credit — normally have a decent amount of financial standing and goodwill.
Trade credit can be thought of as a kind of 0% interest financing. It is also known as vendor credit or “net terms”, and can be seen as a type of working capital finance and a form of alternative funding.
Trade credit — considerations
Companies that offer trade credit, typically give buyers anywhere from 7-120 days — to pay for any goods obtained. Transactions are recorded through invoices — which state the quantity of goods, the value of goods and the repayment dates.
Trade credit greatly benefits the buyer. Buyers always want to make payments as late as possible — while suppliers or sellers want to get paid earlier. Sellers will usually have specific lending criteria that buyers will need to meet — before qualifying for trade credit.
Trade credit allows companies to receive, make and sell goods before ever having to pay for them. This potential revenue stream, covers the costs of goods sold — leaving companies to pocket the difference (the profit). Domestic and international business deals can involve trade credit terms.
Fundamentally trade credit increases a company’s assets — while deferring payment to the future. It is an excellent way for businesses to manage their cash flow — enabling money to be deployed elsewhere. Further, as there are no intermediaries (banks) — it is a cheap way to acquire valuable goods.
Sellers also benefit from trade credit deals, as it lets them expand their operations and sell to more markets. In theory this is at no cost — as vendor credit simply extends payment terms (rather than gives items away for free). However, there is the risk of delayed or even non-payment.
Accordingly, sellers often have two prices (or they just offer an early payment discount) — one for paying straightaway and the other for paying later. Unsurprisingly, paying later frequently involves paying a higher price, for the same goods, to compensate for risk.
Many firms, particularly in building and construction trades like roofing, carpentry and decorating, rely on trade credit.
There are a number of insurance products related to trade credit — generally referred to as trade credit insurance. This protects suppliers from bad debt — where firms take on trade credit, but eventually default on payment.
Trade credit is similar to sellers giving products to vendors — on consignment. Under the terms of consignment, the original supplier retains ownership of the goods — until the trader sells them on.
How does trade credit work?
Each and every supplier would have their own trade credit qualifying criteria, and terms. Suppliers commonly consider a few things including trading history, the risk your business presents, the type of goods on offer and lastly your relationship with them.
Sellers may agree to supply you with goods, under certain trade credit terms. For example, you may be offered terms where you have up to 90 days to pay for goods received. Should you make a payment within 60 days you would enjoy a 10% discount — while payment within 30 days enjoys a 20% discount.
You then have multiple options. You could simply wait out the 90 days — selling the goods and making use of the cash elsewhere e.g. to employ more staff. Alternatively, you also have the incentive to sell the stock as fast as possible — in order to benefit from the discount.
Your supplier may also be receiving trade credit from their suppliers. Consequently, they will benefit in the same way your business has i.e. allowing money to be used elsewhere or enabling them to get supplies at a discounted rate.
Benefits of trade credit
- Can help startups get operational
- Can accelerate business growth for both buyer and seller
- Typically an interest free funding solution
- Relatively easy to arrange
- Improves buyer-seller relationship
Limitations of trade credit
- Hard to get for brand new (buyer) businesses
- Late payment fees may apply — for buyers
- Buyer non-payment risks
- Supplier may experience cash flow challenges
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