4 min read20 January 2020
Trade credit is a form of short-term B2B financing that can free up working capital and finance growth. Use it wisely and the benefits just keep on coming.20 January 2020
Without trade credit, cash goes out of your business when you buy stock or materials and comes in again when you sell to your customers. But with a trade credit agreement in place, you're Harry Potter. You get the goods now, but keep your cash until payment is due days or weeks later. So, if you sell before that time, money comes in before it goes out. And, as long as you add value, more comes in than goes out.
What is trade credit, exactly? How does it work? What are the benefits? Are there any watch-outs? Is it true 80-90% of world trade relies on trade credit financing of some kind?
To answer the last of those first: Yes, according to the World Trade Organization. For a guided tour of what trade credit is and why it's important, read on.
The textbook trade credit definition: trade credit is a B2B agreement where a customer can take delivery of goods, stock, materials, equipment or services, but delay payment until a scheduled future date. Phew!
In other words, trade credit is when one business agrees with another to supply something now and let the other business pay later. Simple.
Let's go deeper.
Trade credit is a two-way business transaction between a supplier and a buyer. Trade credit terms are agreed up front, often simply by one company deciding to do business with another. Usually, the supplier gives the buyer 30, 60 or 90 days to pay.
This means you get the goods up front without handing over any cash. You then use or sell these goods in your business and use the money you get from your customers as payment for the invoice you get from the supplier.
That's trade credit in a nutshell. Now let's look at how it works.
Cost control, cashflow management, financial leverage, capital release, financing for growth… Trade credit is the bedrock of business, the greatest facilitator of global and local trade from supermarket shelves to shipyards.
If you're on the receiving end, it's like having a short-term, unsecured, interest-free loan to buy the goods and materials you need. This puts assets in your hands that your business can use to generate income – with no drain on your working capital and a lot less pressure on your cashflow.
Some businesses simply couldn't exist without trade credit. Construction, shop-fitting, retail… Imagine having to pay for everything right away, all that cash tied up until the money comes in from your customers.
But there's another important side to trade credit. Most suppliers incentivise early payment to help their own cashflow. The deal might give you 90 days to pay, but a 2% discount if you pay within 14 days. This helps drive efficiency as you seek ways to create revenue sooner.
Terms may be negotiable. Heavyweight buyers might play one supplier's terms against another's. A start-up business might win round a supplier when bank loans aren't on offer. Buyers with seasonal demand might ask for a temporary increase in credit limit.
In finance, trade credit is a form of deferred payment. In business, it's the foundation of a mutually profitable relationship.
As with any financial agreement, trade credit has both advantages and disadvantages, and these differ for buyers and suppliers. Trade credit can fuel growth, increase turnover, add a competitive edge, engender loyalty. But it can also expose suppliers to cashflow problems.
On balance, trade credit works to everyone's advantage, as long as risks are understood and properly managed. No surprise, then, that larger businesses assign a dedicated credit manager to keep things on track and optimise the relationship.
Benefits galore for buyers, and not so shabby for suppliers either. Trade credit helps cement long-term partnerships. It gives both parties reason to pull together. This synergy is invaluable.
The biggest downside to trade credit is the potential knock-on effect if things don't go to plan. For buyers, the penalty of failing to keep up your side of the deal can add to your costs and sour the relationship. But for suppliers, it could be far worse. If a company goes under and debts remain unpaid, suppliers can face an uncertain future.
Debt default can cripple a business. Credit insurance protects a supplier against excessive late payment or non-payment for goods or services supplied on credit.
Sadly, insolvency, where a business cannot pay its debts, is not uncommon. A credit insurance policy gives a supplier peace of mind that someone else's cashflow problems won’t have serious consequences for their own business.
With international trade and government intervention a political football, credit insurance can also help safeguard businesses from wider risks.
While trade credit has no direct costs the way a bank loan does, there are indirect costs and a price to pay if things go wrong.
For most businesses, trade credit has a part to play. But you should be aware that trade credit isn’t a long-term source of finance. The strength of the trade credit model is the rinse-and-repeat factor. You get the goods, you add value, you sell and use the proceeds to pay your supplier's invoice.
Trade credit is all about the short term. Sure, you can build a long-term business relationship with trade credit, but if you need longer-term business finance then iwoca’s Flexi-Loan could be right for you. You could borrow up to £200,000 for your business. It takes minutes to apply and you could have the funds in your account within 24 hours. Applying costs nothing and won’t damage your credit score.
Download our free guide for start-ups and small companies looking for finance to help them grow. It covers the different types of finance, examines their pros and cons, and includes some useful tips.Send me the guide
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