Short-term Financing:
Trade Credit 

Understanding how to leverage this financing source to grow your business

Updated October 31, 2020

Did you ever think that getting your business needs met immediately doesn’t have to be so complex? If your company normally makes big purchases through outside vendors to obtain things like office supplies or furniture, inventory to fill your stockroom or whatever raw materials your business needs to produce its products, then the top place to get the funds you need to buy those things could essentially be your vendors. Find out how to maximize this hidden source of financing being utilized by millions of businesses worldwide.

What is trade credit in business?

Trade credit, also called business credit, is when one business extends a loan of some type to another business so they can buy the items they need. It is used when the buyer doesn’t have the immediate funding to purchase a needed commodity to run their business, so the other business takes a chance on them and provides funding on a short term basis, which ranges from a few days to normally up to 120 days to get paid back.

Trade credit is one of the biggest sources of capital for many business to business arrangements in the United States. Even large retailers like Walmart has at one time or another used a form of trade credit.

Understanding how trade credit financing works for small businesses

Trade credit is very beneficial for a small business to be able to get the needed products or services they must have to survive, as especially if they are just starting out they may not have the credit to borrow from a traditional location like a bank or credit union. Plus, the suppliers also benefit from this transaction because it helps them build new partnerships and in the long run they get more profit via the contracts they form with the borrower. Many times this becomes a long term agreement between the two and is a permanent arrangement that benefits both parties.

This is especially true if the borrower is a new business or start-up. It is very difficult for such businesses to get the supplies they need since they may not have any money at the start of their business. Plus, traditional lenders are not likely to trust them enough to loan them funds. Therefore, if trade credit is used and all goes well, the start-up is aided in building their credit, plus the supplier is aided because they get all the start-up company’s business in the future if things work out successfully between them.

Advantages and disadvantages of buying with trade credit

Advantages of trade credit

There are obviously many advantages to buying goods and services via trade credit.

0% interest financing

For one thing, there are usually no interest charges, so that saves the customers a lot of money. Plus, dependent on the time frame of the agreements, which as previously stated is normally between 10 and 120 days, the borrower has time to sell the products and services they bought with the borrowed funds, and can thereby easily pay back the supplier.

Building commercial credit score rating. 

Plus, as long as the borrower makes good on these arrangements, the actions are reported to the credit bureaus in a positive fashion. This is called trade references and it helps the borrower to build a credit history and get a positive credit score. This will be used by other lenders in the  future, so it widens the business’ chances of borrowing larger amounts as they grow their business in the future.

Disadvantages of trade credit

On the other hand, there are many disadvantages to consider before buying goods and services with trade credit.

Harder to qualify for new businesses and startups 

Without a credit history,new businesses may find that trade credit is harder to obtain. Suppliers usually require upfront payment for startups.  

Loss of early payment discount

The savings from early payment discounts offered by suppliers are foregone.  

Administrative costs  

Buyers would need more resources to keep track and manage invoices and payments.

Penalties and interest charges for late payments   

Most suppliers and vendors have credit payment terms and conditions that include penalties and interest payable on outstanding credit for late payments.

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Types of Trade Credit

There are at least three kinds of trade credit, including:

Trade Acceptance – With this kind of trade credit agreement, the borrower and the supplier have some type of formal paperwork that spells out the terms of the agreement. The seller sets up the terms of what they are giving to the borrower as well as how long the payback terms are, if there are any discounts for early payback, etc. Then, the borrower must accept these terms and sign the paperwork. Then, the borrower gets his funding or the products and services agreed to in the document.

Open Account – In this time of trade credit, there is no formal paperwork between the borrower and the supplier. However, this type of agreement is fluid and could change, as well as it holds more risks for both parties since there is no formal signed agreement.

A Promissory Note – A Promissory Note is a type of formal document spelling out the agreement between the borrower and the supplier. It is normally used to extend the credit for some sort of open account between the two that already existed, but for whatever reason needs to be extended or maintained.

How suppliers and vendors evaluate qualifications before extending trade credit to their customers 

There are several criteria used when determining if trade credit will be given, as well as the amount, terms, etc. to include:

Business size

Small businesses or start-ups are usually the type that require more dependence on being able to obtain trade credit. This is due to the fact they have a harder time getting loans from traditional places like a bank or credit union. However, these small and new businesses may find it harder to obtain trade credit than the larger more established companies that also use it.

Business category

Trade credit terms and amounts also may differ dependent on the business category trying to get it. Some types of business rely on trade credit more than others. For instance, if a business has a monopoly on a certain type of product or service they may require payback upon delivery of the goods or services, while if the business deals in some sort of inventory where they have a turnover, for instance, of two weeks for selling their items, but the trade credit provider gives them Net 30 terms, they are using the borrowed funds as part of their working capital.

Nature of products or services

If the buyer has products or services with a fast sell rate or high turnover, they usually will be given shorter payback terms, but if they are in a business where the times are high cost and expected to take longer to sell, these business will normally get longer payback terms as well as more money from the supplier.

Buyer’s credit score rating

The borrower’s commercial credit rating is going to be a huge influence over the amount of funds they can borrow, as well as the payback time frame. If the business, for instance, is a startup with no credit history, they likely are going to be asked to pay the funds back much faster as well as be offered much less of a loan than if the business is more established and has a good financial background.

Supplier’s financial status

The supplier’s financial standing is also very vital in determining the amount of funding and payback time frame. If the supplier is larger, they may not demand a short payback time frame from the borrower since they can better afford the wait. For instance, if the supplier is providing goods based on consignment, they normally provide extra funds to the merchant the goods come from, and pay a commission to the consignee when these goods sell. So a small business is then able to get a larger amount of inventory for their company than if they were not able to borrow via trade credit. However, dependent on the creditworthiness of the borrower, they may have to accept stricter terms to provide less risk to the supplier.

Supplier's risk appetite

Of course the degree of risk for the supplier is always a consideration in a trade credit agreement. The supplier must determine the risk they have when they decide to provide goods or funds to the borrower, and that dictates the trade credit terms.

Key factors determining the terms of trade credit payment period

The time frame for a buyer to be required to pay back a trade credit agreement is decided based on several factors. It can also differ depending on the industry involved. For instance, something with high cost items like jewelry likely would have a longer payback schedule than a business whose products are perishable, such as if they sell food. Normally the factors considered in determining a payback period include:

Likelihood of non-payment: The probability the borrower will not pay back the lender, i.e. the borrower’s business is in some way high risk and they have fewer customers. This type of borrower is likely to be offered more restrictive types of trade credit terms.

Transaction size: How big the transaction is expected to be – If the amount of the loan or value of the goods to be purchased via trade credit is small, the expected payback time frame is going to be small, i.e. something like Net 10 or Net 15. But if the amount of the transaction is larger, or the items are high cost, the time frame could be extended to as much as Net 120 or even Net 180.

Type of goods: The degree to that the borrower’s goods will be perishable –Normally if the transaction or loaning of funds is for a perishable item, the supplier is likely to offer less trade credit than if the items are not perishable. This is because the borrower has to sell the perishable goods quicker than non-perishable so there is more of a chance they won’t get the money they need to payback the borrower on time.

What are the most common payment terms for using trade credit?

There are several common kinds of payback terms for trade credit ranging from Net 10 to Net 120. The numbers merely stand for the amount of days the supplier of the trade credit is allowing for the buyer to pay them back. In cases of very high value products, occasionally the terms will be as long as 180 days. Usually the payback terms include Net 10, Net 15, Net 30, Net 45, Net 60, Net 90 and Net 120.

When a business makes a trade credit deal with a supplier, the transaction is normally done via a special kind of invoice. It is usually a zero interest arrangement, but that depends on the deal the two businesses make with each other, as well as the length of time they are expected to pay back the borrowed money.

Depending on the agreement, some suppliers build in a discount if they get paid back sooner than the agreed upon arrangement. For instance, they could give a 2 percent discount on the amount if the borrower pays them back prior to the stated terms. These early payment discounts are used as an incentive in order to create sales, as well as provide different options for the supplier and buyer to conduct business.  

Types of Businesses Using Trade Credit

Statistics have shown that a large percentage of small businesses don’t have the cash on hand they need to do business. So, in order to make a profit and provide goods or services to their customers they rely on trade credit agreements. This way they get what they need and can provide for their customers and stay in business.

Trade credit agreements can be found in nearly any business category as long as one business is willing to make an agreement with the other. Common types of businesses that use trade credit include:

  • Cleaning services (so they can get the supplies, etc. they require and once their customers pay them for services, they pay the supplier each month).
  • Creative agencies (these too provide trade credit to their clients, then send monthly invoices out for getting paid back.)
  • Accountants and bookkeepers (these are normally small firms who deal with several businesses, and send out monthly invoices).
  • Landscapers. (These businesses need trade credit to buy things like fertilizer, chemicals, etc. and may offer their clients some sort of trade credit net terms in monthly invoices.)
  • Clothing businesses. (These may use trade credit to buy large amounts of for instance, plain t-shirts in various colors, then they put their own designs on them, sell the shirts to customers, and can then payback the trade credit supplier.
  • Restaurants. (these use trade credit to buy their ingredients from food service suppliers, then they turn those ingredients into meals for customers, and use the resulting funds to pay back the supplier.
  • Drink manufacturers. (for instance, a beer brewery needs to use trade credit to purchase their ingredients and tools to make beer. Then when they brew and sell the beer to customers, they use those funds to pay back their suppliers.
  • Construction companies. (They use the trade credit for buying supplies like nails, wood, etc. and then pay back the supplier after they build, for instance, a house.)
  • Other types of manufacturers. (They use trade credit to buy whatever goods they need to make their products, and after selling these products to customers can pay back the supplier.)
  • Wholesalers or retailers. (Same as others, they buy items they need to sell via trade credit and then use the profits to pay back the suppliers.)

 

All in all, if you are seeking trade credit, you need to do several things. Firstly, you need to seek out a vendor or supplier to use. You should base your decision on the one that offers you the best payback terms. Then, you fill out the supplier’s application, not unlike filling out a credit application for a credit card.  This provides your business name, length of time in operation, contact info, amount desired, etc.

Then, the supplier likely will run a credit check on your business. If they decide to approve your application, then you will sign the agreement if you agree to their terms of payback. 

Examples of trade credit

When it comes to trade credit, here’s an example to help you to understand better how it works:

For instance, let’s say someone owns an ice cream stand via a franchise agreement. The franchise distributor then provides the trade credit in the form of the ice cream stock the stand needs to sell to do business. They agree to Net 60 payback terms, so the ice cream stand owner has sixty days to pay for the provided ice cream. The distributor may include discounts, i.e. if the ice cream stand owner pays the funds for the ice cream back faster, they could, for instance, get a 1 or 2 percent discount.

The bottom line on trade credit financing

All in all trade credit can be an awesome way for startups and small businesses to get the cash flow they need to start and maintain their business. If used properly it can be a way to grow the business and ensure a good partnership with the supplier for the lifetime of your business.

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