Trade credit can be a seriously powerful financing tool for managing cash flow and removing roadblocks from your supply chain.
But is it right for you?
Using trade credit does come with some inherent risks, and like anything finance-related, it has a few pros as well as cons.
In this article, we’ll take a look at what trade credit actually is, discuss advantages and disadvantages, provide real-life examples, and dive into some best practices for managing trade credit more effectively.
What is trade credit?
Trade credit is a financial arrangement between you and a supplier, whereby you can receive goods or services without having to pay upfront.
Instead, the supplier sells them to you on credit, meaning you can receive the goods or services now and pay for them later.
Credit terms generally range from 30 to 90 days, which can give you as much as three months to pay an outstanding bill.
Using trade credit has a positive impact on supply chains since you don’t have to wait until payment is made and cleared to receive what you need.
It's also a great financing tool for business-to-business transactions, allowing you to plan and manage cash flow better.
Is it worth it? Trade credit pros and cons
Trade credit might not be appropriate for all businesses or scenarios. And if you’re considering opening up a credit line with a supplier, it's a good idea to be aware of the pros and cons involved.
Advantages of using trade credit
Using trade credit opens up some serious advantages for managing cash flow.
Instead of having to make a payment every time you order goods or services, you can schedule payments to vendors at an appropriate time during the month, such as after you’ve received payments from your own accounts receivable, avoiding using overdraft facilities.
Additionally, using trade credit allows you to be smarter about how you use the cash you have on hand throughout the month, allowing you to invest in more strategic initiatives.
Flexibility in payment terms makes life easier on your accounts payable team, too.
When all invoices for a given vendor can be paid at once, your AP team can process batch payments and better organize their time, rather than having to process payment each and every time procurement needs a new good or service.
Finally, consistent use of trade credit and timely repayment can build trust between you and your suppliers, leading to stronger, more reliable business relationships that can be leveraged to negotiate more favorable terms in the future.
Disadvantages of using trade credit
Using trade credit is not risk-free. However, most of these risks are related to late payments.
If you fail to meet repayment timeframes, many vendors will begin to charge interest on your outstanding amounts, which can be much higher than if you had used another form of business credit.
There is also a risk of late payments affecting your company’s creditworthiness if things get really bad.
Overextension is another risk here. Some businesses may overextend by ordering too much on credit and not effectively planning their incoming cash to meet repayment obligations, leaving them paying their bills late.
All of these risks, however, can be mitigated by effective cash flow management.
Examples of trade credit in practice
Here are three examples of trade credit being used in different industries to give you a better understanding of how it works in practice.
- Retail. A clothing wholesaler sells a batch of garments to a retail store on trade credit, with payment terms of net 60 days. The retail store has 60 days to pay the full amount, and can receive a 2% discount on the invoice total if the invoice is paid within 10 days.
- Marketing. A startup engages a marketing agency to create and execute a social media marketing strategy. The agency agrees to take a 25% upfront payment for services rendered, with the remaining 75% being extended on trade credit with a 30-day payment window.
- Food and beverage. A produce supplier delivers fresh ingredients to a local restaurant every Sunday night for the week ahead, allowing the restaurant to use them to generate revenue before the payment for the produce is due. The supplier offers credit terms of net 15 days, aligning with the quick turnover of inventory.
Trade credit terms you need to know
Trade credit uses a few technical financial terms. If you’re going to be leveraging trade credit in your own organization, you’ll want to have them under your belt.
Here’s a quick guide:
- Terms of sale. Any conditions under which the sale is made, including payment terms such as the credit period. They are often written as “2/10, net 30”, where 2 is the discount rate, 10 is the discount period, and net 30 is the credit period.
- Credit period. How long you have until payment is due.
- Discount period. The number of days within which you can pay your invoice early to receive a discount.
- Discount rate. The percentage your invoice is reduced by if you meet early payment requirements.
Best practices for managing trade credit effectively
Work on your negotiation skills
Trade credit terms are always up for negotiation or at least a discussion.
By brushing up on your negotiation skills, you might be able to extend a 30-day payment window to a 60-day one or open up an early payment discount.
Get on top of payment schedules
If you manage your payments to suppliers effectively and make payments on time, it’s all upside, and you’ll do away with the disadvantages we discussed earlier.
For this, you’ll need to work on optimizing your accounts payable process, utilizing powerful software features like automated invoice matching and approvals workflows.
Improve and optimize cash flow
The biggest risks associated with using trade credit all disappear when you manage cash flow effectively.
Modern financial management software tools can help here, too.
They can help you program automatic payments to meet credit terms or access early payment discounts, forecast cash flow, and keep on top of incoming payments to ensure you have enough cash on hand to meet debt obligations.
Use trade credit strategically
Trade credit isn’t necessarily something you’ll use for every purchase.
It's still helpful, for example, to have a charge card or some petty cash on hand for those small, immediate purchases.
There’s no need to negotiate credit terms with your local corner store for when the office needs to quickly buy some more milk!
Instead, use trade credit strategically by negotiating trade credit terms with your most commonly-used suppliers and aligning payments with revenue cycles to reduce the need to dip into overdrafts or use other credit facilities like credit cards.
5 trade credit myths debunked
1. Trade credit is the same as a bank loan
Trade credit is very different from a bank loan.
Bank loans involve borrowing from a financial institution, which comes with interest charges and often requires collateral to secure the loan.
Trade credit is offered by your vendors and is essentially a formal agreement to let you pay for goods and services several weeks after you’ve received them.
2. Trade credit is only for struggling businesses
All kinds of businesses can and should use trade credit.
In fact, struggling businesses are probably better off avoiding trade credit in most cases, as it's more likely that they’ll be unable to meet repayment requirements and, as a result, negatively impact their credit scores.
Businesses that are able to manage cash flow effectively can use trade credit as a powerful tool for improving supplier relationships and optimizing cash flow further.
3. Trade credit terms are non-negotiable
While most suppliers will have standard terms for credit terms and discount periods, these are often negotiable.
This is especially true once you’ve established trust with a supplier by operating on credit terms for several months and meeting repayment requirements.
4. Trade credit is only for small purchases
Trade credit can be used for purchases of any size and is often an effective solution for large purchases that might be difficult to make in advance, allowing you to wait until you have cash on hand from customer payments.
5. Trade credit is risk-fee
Trade credit does come with financial risk, though most of this risk is related to late payments.
If you fail to meet the terms set out in your vendor agreement, you could be charged interest and potentially have your business's creditworthiness negatively impacted.
Trade credit can be a powerful tool for cash flow management
Activating trade credit terms with your vendors, especially those from you who buy very often, can be an effective way to improve cash flow management.
While there are some inherent financial risks involved with using trade credit, effective management of payment due dates can reduce this risk to near zero.
Accounts payable automation solutions like BILL are your best friend here, allowing you to program payments in advance, route invoices through an approval workflow, monitor incoming cash from customers, and forecast cash flow in advance.
