Trade Credit: How It Works for Buyers and Suppliers
Having the cash on hand at any given time to finance major business operations is tricky. We’re particularly talking about inventory, raw materials, or supplies to drive operations. That’s why trade credit exists: To help you gather the cash needed to pay off those bills over time.
Because, yes, although you’d love to have thousands — or maybe hundreds of thousands — of dollars immediately available to pay your vendors as soon as you purchase goods, it’s unlikely that you do. Or, at least, that you can constantly do it that way. Again, this is why trade credit exists. Here’s how it works and how it affects both buyers and suppliers.
Trade credit: Defined and explained
If you’ve ever heard someone use the phrase “net terms,” then you’ve heard of trade credit even if you didn’t know it by its other name. (Luckily, a rose by any other name smells as sweet, right?)
In simplest terms, trade credit is a short-term financing agreement between a buyer and a supplier. The supplier extends credit to the buyer, allowing them a designated period of time after delivery of the product or service to pay the fee. Those “net terms” you’ve heard of are the period during which the vendor has agreed to extend credit. So, net 30 means 30 business days, net 60 means 60 business days, and so on.
Trade credit is also the easiest type of short-term financing to get as it doesn’t involve a formal application process. And, since 25% of small-to-medium business owners (SMEs) are denied financing from lenders due to poor earnings and cash flow, it’s an essential part of the trade ecosystem.
What is trade credit used for?
Trade credit is used to facilitate the purchase of large goods and service contracts. (Even smaller purchases, too, depending on the relationships in place with suppliers.) With trade credit, businesses can purchase what they need at once and stagger repayment across vendors.
Also, implemented intelligently on the part of the buyer, trade credit also gives businesses the flexibility to make sure that they will have enough money to cover all of their trade credit bills on time.
What kind of businesses use trade credit?
Lots, actually. Trade credit is a business-to-business (B2B) service. But it’s very well utilized across industries. Restaurant owners buy from their ingredient suppliers on net terms. Lawn care companies bill their homeowners using trade credit. Strategy consultants extend a line of trade credit to their clients.
With that in mind, though, a buyer doesn’t automatically get trade credit just because they want it. You’ll want to think about trade credit as a tool for building relationships between businesses — and, subsequently, building business credit with continued payment on time and in full. A supplier won’t extend a business a trade credit line unless they have solid trust that they’ll be recouping all of their money at the end of the time frame.
Advantages of trade credit
- More time to pay. It’s hard to come up with the money you need to pay for major purchases all at once. Trade credit extends your window of payment from COD (cash or collect on delivery) to the terms you and your supplier agree on.
- Build business credit. Trade lines of credit help you establish business credit. Some major credit bureaus take trade credit into account when calculating business credit scores.
- Potential discounts. Many suppliers will offer small discounts to incentivize buyers to pay before their due date. You might be able to save money if you can pay before your bill comes due.
- Open up more relationships. The vast majority of buyers rely on trade credit for large purchases. Offering this financing for buyers can open up new relationships and potentially larger purchases with existing ones.
- Becoming a preferred supplier. Customers may favor you if they’re able to negotiate favorable trade credit terms with you that aren’t available through competitors.
Drawbacks of trade credit
- Potential discount loss. This is more opportunity cost than anything. Still, if you wait to pay your invoice until its due date, you forego any potential discount the supplier might offer if you pay upfront in cash.
- Relationship risk. If you aren’t able to pay on your bill for services rendered or goods received, you risk putting your relationship with your vendor in jeopardy.
- Risk of delinquency. When you extend trade credit, there’s no guarantee that you’ll get your payment on time — or at all. And although you’ll only extend trade credit to the customers you trust, you’re still taking a gamble on their business.
- Discounting. In order to incentivize your customers to pay before their terms come due, you might have to offer some form of discounting for early payment. This will cut into your margins.
- Uneven cash flow. The nature of trade credit means you don’t know when your customers will pay. This creates an inherently uneven, unpredictable cash flow. While you want to be flexible, you also want to set terms that favor your business as well.
Establishing trade credit with suppliers
As we mentioned briefly, you can’t just have trade credit simply because you want it. There’s a deep trust involved in establishing payment terms with a vendor. If they extend you financing, they need to feel secure that you’re going to come through with their cash if they front you what you’re buying.
How to establish a trade credit relationship
The good news is, unlike traditional short-term financing, you don’t have to apply for trade credit. The less-good news is that you’ll generally have to begin at square one with a new supplier. That means starting with COD — or even up-front payment, depending on how your vendor works. Then, you might graduate to deposit, installment, or other net terms. But that’ll depend on how quickly and how well you can provide to your supplier that you’re dependable and creditworthy.
Much like a business lender, the business on the other end of the trade credit line wants to mitigate their risk as much as possible. So, although they’re not formally underwriting you, they’ll be judicious about whether or not to extend you advance payment terms.
If a potential partner doesn’t know much about you, they might opt to pay to check your business credit score to see your history with business debt. (This is a service that many of the major credit bureaus provide.) This is just one reason why it’s important to establish trade credit relationships when you can and keep up on top of them once you have them. Proof of past positive relationships can go a long way in building future relationships.
That first one can be tough to get and take time — but it’s crucial to open doors down the line!
What happens if you don’t honor your trade credit agreement
Your suppliers offered you trade credit because they trusted you, right? Don’t lose that trust! But you will if you can’t come through on your payment.
Not only will you very likely lose your opportunity to work on delayed payment terms with your vendors, but some may never choose to work with you again. They also might influence others not to extend you trade financing — especially if you work in a tight-knit industry.
Worst case scenario: It’s possible that if you owe a large payment, your supplier could hire a lawyer and send a collections agent after you.
Remember that even if you plan to pay, albeit late, suppliers are depending on your money. They factor your on-time payment into their cash flow. Coming up short could affect how — and if — another business is able to pay other suppliers, lenders, or finance their own operating costs. That’s a cascading effect! If you have a down month and need more time to pay, let your supplier know as soon as possible.
Offering trade credit to customers
On the other side as a supplier, you’re taking a risk if you decide to offer financing. And it’s important to understand the risk: SMEs spend nearly 15 days a year chasing payment on outstanding invoices.
But, if you size your risk correctly, you could be opening up your customer base.
Determining whether or not to extend trade credit
The first question to ask yourself: Do you have an existing relationship with this customer? Do you have a way to know if they have a good history with payment? If the answer is yes, you might begin by asking for a deposit or a portion of the invoice COD and extend net terms for the remainder of the invoice. Then, with time and proven responsibility, you can move toward a full trade credit relationship.
If you don’t have any way to gauge a company’s history, you can also either check their business credit score to get of sense of how they’ve handled past debt. Alternately, you can ask for a trade credit reference from other vendors with whom they’ve worked.
Offering an early payment incentive
To incentivize faster and guaranteed payment, many suppliers choose to offer a cash discount. A common discount is 2/10, or 2% off the price of the invoice if paid in 10 days.
Yes, that technically cuts into your margins on your product or service. But having the cash in hand to be able to put back into operating costs or invest, and knowing you won’t be out that money later, is worth it for many businesses.
What to do if your customers don’t honor your trade credit agreement
This is the chance you take, of course. Before anything, you’ll want to send out a late payment reminder. Don’t assume the worst!
In the interim, you might want to look into a solution like invoice factoring. It’s meant for a situation just like this! With invoice factoring, you sell your unpaid invoice to a factor (lender) who’ll pay you a significant portion of the balance. Then, they’ll pursue the outstanding payment from your client, and pay you the remainder, minus their fee, once they collect. This helps a lot with cash flow!
How trade credit affects cash flow
You’ve likely figured out by now that there’s a very direct tie into trade credit and cash flow. That goes regardless of which side of the terms you’re on.
As a customer…
- You’ll be able to plan your invoice payment based on your cash flow projections.
- You don’t have to pay COD or pay for everything at once if you don’t have the cash on hand for it.
- You can stagger payments across multiple trade credit lines based on available cash flow.
- You can take advantage of discounts if you have the available liquidity and know that paying in full early won’t affect your working capital.
As a supplier…
- You might introduce an element of unpredictability into your accruals depending on when your customers actually pay.
- You introduce the possibility of late or non-payment after services are rendered or goods are delivered.
- You might want to take advantage of invoice factoring to access cash tied up in trade credit.
With this in mind, the most important thing you can do on both sides of the equation is have the best handle on your cash flow possible. The more you know about the cash you have on hand, the more you’ll understand whether or not you’re able to either extend trade credit or pay off your invoices. That means you need to be able to forecast and project your cash flow accurately — the more data, the better.
ForwardAI Predict cash flow forecasting tool does just that, nearly down to the minute, by integrating with your accounting software to create an interactive and informative dashboard.
Signing up for ForwardAI Predict is easy. Just create your free account, connect your business and run your cash flow forecast.
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
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