What Is Trade Credit, and How Can It Help Your Business?
New businesses often have trouble securing financing from traditional lenders. A startup’s short credit history rarely offers enough reassurances to satisfy the strict lending standards of banks and major financial institutions. Many new companies have worked within these constrains by utilizing trade credit – receiving products or services in return for a promise to pay the supplier within a set amount of time – rather than approaching a bank for a loan at all. These business-to-business arrangements can offer advantages and drawbacks for both the client and supplier. When used successfully, trade credit can help companies get on their feet and begin to establish business credit. In exchange, suppliers may earn new business – and loyalty – from startup clients.
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. Most suppliers want to build new business relationships that will lead to further purchases, not profit off of fees.
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.
It’s important to note that these benefits can also be enjoyed by established companies – even those that may qualify for traditional loans. Business owners sometimes prefer to finance their purchases directly through the supplier. Trust between owners – and the possibility of a discount – could make other lenders less attractive.
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 a number of ways that offering trade credit to businesses can benefit 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 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. If a business hasn’t yet established 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 terms of a trade credit agreement.
While extending credit has much to recommend it, it is not without potential pitfalls: Businesses that offer trade credit run the risk that clients will fail to repay them. They then find themselves in the unfortunate position of having to pursue bad debts, which distracts from the business’s day-to-day operations. 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.
Whether you’re receiving or extending trade credit, understanding the terms of the agreement is crucial. Unlike bank credit, trade credit financing is relatively short, usually unsecured, typically offers discounts for early payments, and is restricted to businesses.
Trade credit terms are often expressed in shorthand. For example, “2/10/30? or “2/10/net 30” both signify that a 2% discount can be claimed when paying within 10 days of invoice issuance, and that the balance must be paid no later than 30 days after the invoice is issued.
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.
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.