A Guide to Understanding Trade Credit in Business
You may find, at some point in your journey as a business owner, that you don’t have easy access to the finances needed to scale your business. You may be trying to bridge the gap between a massive purchase order and a customer’s final payment. At this point, you’ll probably need to lean towards trade credit. But how does it work, and what does this mean for your business?
For a business like yours, trade credit is an invisible form of financing – an interest-free loan from your suppliers that can help grow your business. This can at times be a more efficient way compared to taking out a traditional banking loan.
Here, we’ll discuss how your business can use trade credit as a way to optimise the cash flow within the business, strengthen supply chains, and get ahead of your competitors.
What is Trade Credit?
Firstly, let’s discuss what trade credit is so that you have more of an understanding of how your business can benefit from it. Simply put, trade credit is a B2B agreement between a customer and a business where the customer can purchase the goods or services and pay the supplier back at a later date.
Trade credit is different in that it usually carries 0% interest, provided you pay back the agreed amount within the specified timeframe. For suppliers, this is a great way to encourage larger orders and to create loyalty and returning customers. Also, this way, you can generate revenue before needing to pay any money.
The Anatomy of Credit Terms
You may have seen codes like ‘Net 30’ or ‘1/10, Net 60’ on your invoices. Here’s what you need to know about these codes:
- Net 30/60/90: This code refers to your grace period. So, if your invoice is dated May 1st with net 30 terms, you have until May 31st to settle the balance.
- The early settlement discount: Suppliers may also offer discounts for paying the money back within a certain period. For example, a term like "2/10, Net 30" means the supplier is offering you a 2% discount if you pay within 10 days. If you don’t pay within the 10 days, you’ll need to pay the full amount within the 30 days.
You’ll need to work out what is best for your business. The 2% discount may sound small, but when you calculate the annualised interest rate you’re saving, it works out to over 36% APR. So, in this instance, it may be cheaper to use credit from the bank to pay back the trade credit early.
How to use Trade Credit as a Tool for Scaling
For SMEs, one of the biggest barriers to growth is the Cash Conversion Cycle (CCC). The CCC refers to the time it takes for money spent on raw materials to be reflected as revenue in the business. The way in which you can calculate this is as follows:
CCC = Days Inventory Outstanding + Days Sales Outstanding - Days Payables Outstanding
The trade credit will directly impact the Days Payables Outstanding (DPO), so by extending the time you have to pay your suppliers back, you shorten your CCC. If you are able to negotiate terms that allow your business to receive, manufacture, sell, and collect payment for the product before the invoice is due, you’ll be running your business on the capital of the supplier.
Scaling Without Dilution
When a business is in need of growth, the obvious choice may seem to ask for a bank loan or to look for outside investment. But both of these options have prices. Trade credit, however, allows you to scale your business in a more organic way.
When you request a higher limit from your trusted vendors, you’ll automatically increase your purchasing power without paying interest or giving up a percentage of your business.
The Operations Perspective
Trade credit is a great tool for operations managers to use in order to mitigate risk and manage relationships. Let’s take a look at how this works.
Building Credit Gravity
One of the most important things within the B2B world is reliability and being able to show that you are consistent in honouring your trade credit terms. The more you do this, the quicker you’ll build gravity with your suppliers, earning you a great reputation within the industry.
If a supplier has limited stock, they are more likely to prioritise your business compared to a cash-on-delivery customer they have barely worked with previously.
Flexibility in Lean Times
Seasonal businesses will rely heavily on trade credit. For example, a retailer might stock up for the Christmas season in October but won’t actually see any of the revenue until late December. So, trade credit acts as a bridge that prevents the business from losing out on cash but still being rich in assets.
The Finance Framework with Trade Credit
As you can imagine, trade credit requires a clear framework and process for credit management purposes and goes beyond just making sure cheques are signed.
The Aging Report
All finance departments need to maintain an Accounts Payable (AP) Ageing Report, which categorises the unpaid invoices into buckets, for example, 0–30 days, 31–60 days, 61–90 days, and 90+ days.
- 0–30 days: These are your current liabilities.
- 91+ days: This is the danger zone. If your business consistently falls into this bucket, it may result in your credit being revoked and your business being reported to credit-referencing agencies. This will automatically cut off your supply chain.
Analysing the Opportunity Cost
An accountant’s job is to identify the most efficient and cost-effective way to pay. So, they will take into account paying early to get the 2% discount, or keeping the cash in high-interest savings accounts for the remaining 20-day period.
Most of the time, the trade discount beats the bank interest rate. If your business has the liquidity, always take the discount.
How to Negotiate Better Terms with Trade Credit
There is always going to be room for negotiation when it comes to the terms of your trade credit agreement. Here are a few tips on how you can do this so that you get the best terms:
- Start small: Your first port of call will be to ask for Net 15, and once you’ve proved that you are a reliable customer over a few cycles, you can ask for Net 30.
- Provide transparency: Try to share your financial statements or a summary of your growth projections with the suppliers, as this will result in suppliers trusting you and extending credit.
- Leverage your volume: If you need to increase your order size, use this as an opportunity to ask to move from Net-30 to Net-45.
- Offer trade references: Make sure you get references from other suppliers with whom you have a good working relationship, so that you can provide these to the new vendor.
When Does Trade Credit Become a Trap?
As with anything in the financial world, trade credit can come with some negatives.
Over-expansion
You’ll need to be careful that you don’t go overboard with agreeing to pay for inventory that you don’t need purely because you don’t need to pay for it straight away. If you over-order and your inventory doesn’t sell in time, you’ll still need to pay back the money.
Damage to Reputation
Your reputation could be at risk, too, and you may find that other vendors don’t want to do business with you or begin to demand cash before delivery (CBD). This will have the opposite effect on your business financially.
Strategic Checklist for Your Business
To ensure you are using trade credit as a growth engine, here’s what you should keep in mind:
- Audit current terms: Make sure you are aware of the ins and outs of the different terms with different suppliers. You may be missing out on early-payment discounts.
- Monitor your credit score: Make sure that you check your business credit score on a regular basis, because any errors can also lead to lower credit limits.
- Automate reminders: Ensure that you use accounting software to notify you a few days before your net deadline.
- Establish a credit policy: make sure there is a process in place for who in your business is authorised to approve any new credit purchases and to set a limit for total trade debt.
Trade credit can be an extremely useful tool in scaling your business when used correctly. It can keep the cogs in your business turning when your cash is tied up in inventory, shipping, and accounts receivable.
It is important to be able to shift your mindset and view trade credit not as a debt to be feared but as a strategic way of growing your business in a more sustainable way. Suppliers will benefit from the trade credit agreement, too, because when you grow, they grow.
Are you looking to purchase business credit checks? Get in touch with Creditserve for more information today.
