Trade credit, what you need to know
A good financial option for buyers who want to use their net profits to pay off their stock or who need to free up some working capital for other purposes.
By Jamie Maddison on 26/11/2018
Trade credit, is a short term funding option which lets you purchase stock or goods without paying cash upfront to your supplier. This kind of debt is usually agreed upon between a buyer and supplier and the extended payment terms are typically for a period of 30-60 days. This may be a good financial option for buyers who want to use their net profits to pay off their stock or who need to free up some working capital for other purposes. This funding option may apply to most businesses for the financing of goods.
Quick-fire facts
- Trade finance allows you to delay payment of stock to a supplier
- It is a low-cost option to free up working capital since it is interest free and typically offers 1-3% discount to buyers who pay early
- This is a good option for companies that only need the capital for a short time period (an average of 30-60 days)
How does trade credit work?
A trade credit involves an agreement between a buyer and supplier to extend the payment period of stock ordered. This enables a buyer to pay for stock typically between 30-60 days after the order is placed.
Not all companies will be eligible for trade credit. Normally this form of working capital is only offered to companies with a good history of repayment. The supplier needs to be confident that they will be paid so they will often only work with businesses with solid credit histories who have proven that they will pay in a timely manner.
How much does trade credit cost?
Trade credit does not cost anything extra but suppliers will typically offer a discount for early repayment. So, it's in the buyer's interest to pay as soon as possible.
Trade credit as a method of freeing up working capital is cheaper than traditional short-term finance since it is interest-free and without additional costs.
However, this kind of short-term finance may be too limiting to businesses which need longer credit terms to pay for the merchandise. It will be important for the business to determine whether they need the working capital freed up for a longer time frame.
Typical Example
Sarah has an e-commerce business and sells on a variety of platforms like Amazon, eBay and two online health food stores. She orders a shipment of superfood supplements from a U.S. supplier based in California. She's worked with this supplier for years. She decides to order more products from her detox line since she expects higher sales after the New Year and in the months prior to summer. Her U.S. supplier agrees to extend her payment terms by 60 days to give her time to sell the products and pay back her suppliers using her net profits.
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What are some advantages of trade credit for buyers?
Trade credits tend to require very little paperwork or hassle as they are usually given through informal agreements. This gives businesses the opportunity to easily increase their inventory during periods of high demand and free up working capital to be able to respond to current conditions better.
What are some of the disadvantages of using trade credit for buyers?
Some disadvantages include expensive late payment fees, limitations (short term periods, need for a strong repayment history and pre-existing strong relationship with suppliers).
This option may also lead buyers to spend more than they need on inventory, overshooting the amount of goods they require since there aren't direct repercussions on their cash flow. This kind of agreement also risks negatively affecting the relationship between the buyer and supplier, particularly if the buyer starts paying right on the due date or worse after payment is due.
If there are no interest fees or extra costs, what are the benefits of trade credit for suppliers?
Suppliers may choose to offer trade credit to incentivise higher sales. By allowing buyers to pay for stock a bit later, they free up working capital for the buyer.
This gives buyers more time to pay their invoices, enabling them to use the sale of goods to pay for the stock.
Alternatives to Trade Credit
If you're planning to apply for trade credit from your bank or other provider, it's worth considering which other finance options might be available for your business. Why not have a read of our related articles below?