Trade credit means many things but the simplest definition is an arrangement to buy goods and/or services on account without making immediate cash or cheque payments.
Trade credit is a helpful tool for growing businesses, when favourable terms are agreed with a business’s supplier. This arrangement effectively puts less pressure on cashflow that immediate payment would make. This type of finance is helpful in reducing and managing the capital requirements of a business.
The reverse situation also needs to be considered; this is where your customers or clients may request favourable trade credit terms. Put simply, any terms agreed with your customers or clients will reduce the benefit you have obtained through trade credit negotiations with your suppliers. For example, if you have agreed trade credit terms of 45 days with your suppliers and trade credit terms of 30 days with your customers or clients, the net benefit will be 15 days. It is the net amount that affects a business’s working capital and a negative capital situation will need additional funding.
When a business enters into a trade credit arrangement with its suppliers, a limit is usually set, commonly called credit terms. For example, you could set cash, cheque or bank transfer payments to be made within 15 days from the date of the invoice, hopefully allowing you to still qualify for any early payment discount. If payments are not made within the terms, all outstanding amounts are required to be settled within the normal time period set from the date of purchase.
Credit terms will differ from business to business and industry to industry. Businesses that receive payments on delivery, for example online shopping sites, may have a shorter credit term than an industrial manufacturer. In that case, projects are spread over a longer period of time and payments may be received periodically on completion of certain pre-decided time slots.
This is short-term finance that is relatively quick to arrange. The typical amount involved and the terms will depend entirely on your trading activity. The reverse is also common, where a business’s customers or clients will request trade credit terms.
There are three main indirect costs of trade credit as there is no direct cost involved:
- loss of early payment discount
- spoiling your relationship with your supplier if you do not adhere to the agreed trade credit terms
- working capital cost if the net effect of receiving and providing trade credit puts your business in a negative working capital situation.
The loss of the early discount can be taken into account when negotiating your trade credit terms. However, spoiling your relationship with your supplier can be more detrimental to your business and in extreme circumstances could tip a business into receivership. Therefore, any deviation from an agreement must be discussed with your suppliers before it becomes a problem.
It is not unheard of for trade credit terms to be agreed on the phone and confirmed in writing later. This will depend on your relationship with your suppliers and your history with them.
- an agreement can be very easy to organise
- an agreement is relatively easy to maintain, as long as the conditions are met
- can be used by most business, for supplies of goods or services
- businesses are protected by late payment legislation
- a potentially low-cost form of working capital finance.
- possible loss of early payment discount
- failure to comply with the conditions could lead to the loss of a supplier
- provision of cashflow advantage rather than additional finance
- your own customers may ask for favourable trade credit terms and therefore cut into any cashflow advantage
- cannot be used by all businesses, such as online retailers
- there are no guarantees, as customers may pay late.
The right finance for your business section of the site gives examples of financial structures that are suitable for different trading types and sizes of business.
Trade credit is a very common form of finance; however, there are instances where a more structured solution will be needed such as cashflow finance/invoice factoring.