Finance

The Advantages & Disadvantages of Trade Credit

Allison S Robinson | 15 June 2022 | 2 years ago

All businesses have to exist in such a competitive environment. Even though it would be preferable to complete all transactions using cash, it’s not always possible to do so. If your competitors are offering credit terms to their customers, you will need to provide something very similar to them if you want to win their business.

Selling products or services to customers on credit comes with both benefits and drawbacks. Credit risks with customers are however huge and you should consider beforehand what these risks are and what effect they would have on your company.

What is Trade Credit?

Trade credit is most likely the simplest and most essential source of short-term borrowing for firms. Trade credit can refer to a variety of things, but the most basic meaning is an agreement to purchase products and/or services on credit rather than making immediate cheque or cash payments.

When acceptable terms are negotiated with a supplier, trade credit can be a valuable instrument for establishing businesses. This method effectively alleviates the cash flow strain that speedy payment would entail. This type of financing is helpful for minimising and managing a company’s financial needs.

Consider the reverse case, in which your customers or clients may request favourable credit terms. Simply put, any terms agreed upon with your clients or customers will limit the benefit earned from trade credit talks with your suppliers. For example, if you have agreed to 45-day trade credit terms with your suppliers and 30-day trade credit terms with your clients or customers, the net gain will be 15 days. The net amount affects a company’s working capital, and a negative capital condition need extra money.

When a company enters into a trade credit agreement with its suppliers, a limit, also known as credit conditions, is normally imposed. For example, you might schedule cash, check, or bank transfer payments to be made within 15 days of the invoice’s date, allowing you to qualify for any early payment incentive. If payments are not paid on schedule, all outstanding amounts must be settled within the standard time period stipulated from the date of purchase.

Credit terms will be different from one company to the next and from one industry to another. Businesses that require customers to make payment upon receipt of their goods, such as some online shopping websites, could have a more limited credit period than an industrial manufacturer. In such a scenario, duties are typically dispersed over a greater period of time, and payments might be paid on a consistent basis depending on whether or not certain pre-determined time slots have been successfully completed.

Why is Trade Credit important to a Business?

If you do not already have access to trade credit, the money that leaves your business to purchase stock or equipment can only be replaced once it is received from your consumers. This means that the cash flow at your company will be negatively affected.

However, if you have a trade credit agreement in place, you will be able to receive the goods right away while helping to keep your cash until the payment is due, which may be a few days or a few weeks later. If you do not have a trade credit agreement in place, you will not be able to receive the goods right away.

If you complete the transaction before that time, you will have the funds in your possession before they are used. As long as you continue to produce something of value, you can rest assured that your revenue will continue to exceed your expenditures.

What is Trade Credit Used For?

There are a variety of uses for trade credit including the management of costs and cash flows, the use of financial leverage, the freeing up of capital, and the provision of funding for future expansion. Trade credit is the bedrock of business and the greatest facilitator of global and local trade. It can be found everywhere, from grocery store shelves to shipyards.

Simply put, trade credit is similar to having an unsecured, interest free, short-term loan to buy the materials that you require. This places assets in your possession that your company can use to generate income, and it does so without putting a drain on your working capital or putting undue stress on your cash flow.

Without access to trade credit, certain types of businesses simply could not continue operating. Building, retail, and shopfitting are some of the industries that we specialise in. Imagine being forced to pay for everything right away, with all of your cash being held hostage until you receive payment from your customers.

However, there is yet another significant aspect to trade credit. The majority of suppliers offer discounts or rebates for prompt payment to improve their own company’s liquidity. The offer might give you 90 days to pay, but it might also give you a 2% discount if you pay within 14 days. In the process of looking for ways to generate revenue more quickly, this helps drive efficiency.

It is possible to negotiate the terms. It’s possible for heavyweight buyers to play the terms of one supplier against those of another. When there are no available bank loans, a potential supplier for a new business could be won over. Buyers who experience seasonal demand may request a temporary increase in their credit limit.

One method of postponing financial obligations is known as trade credit. When it comes to doing business, it’s the cornerstone of a relationship that can benefit both parties.

Getting Trade Credit

If you are just starting out, you will have to pay in full before the item is shipped to you or pay in cash upon receipt of the item until you can demonstrate a payment history.

You can, however, move quickly from cash on delivery to a trade credit agreement if you build a good relationship with your supplier and work on maintaining that relationship:

  • Establish a payment history. If money is tight, you may want to consider purchasing smaller quantities of supplies more frequently in order to demonstrate that you are a loyal customer. Ensure that payment is made in advance and that payments are processed without any issues.
  • When you request trade credit from suppliers, they will want to know whether or not your company can be relied upon, so make sure to provide references. Give the company two or three business references, and ask them to vouch for your ability to make payments on time.

Trade credit advantages and disadvantages

Trade credit, like any other type of financial arrangement, comes with its fair share of benefits and drawbacks, the nature of which varies depending on who is using it (buyers or suppliers).

Trade credit can be used to fuel growth, increase turnover, add an edge in competitiveness, and boost loyalty between businesses that work together. However, this does run the risk of putting some suppliers in a position where they have cash flow issues.

As long as the risks are recognised and dealt with in the appropriate manner, it is probably accurate to state that trade credit is beneficial for all parties involved. It should come as no surprise that larger businesses hire a devoted credit manager to ensure that everything stays on track and that the relationship is maximised.

What are the primary advantages of using trade credit?

  • Facilitates cash flow for the purchasers.
  • Creates room for additional operating funds
  • Price breaks for paying in advance
  • Reduced costs of operation
  • Simple to assemble
  • Instrument of bargaining
  • Develops interpersonal connections
  • Fuels growth
  • Offers a competitive advantage
  • Can be helpful in financing new ventures
Buyers will enjoy a plethora of benefits, and sellers won’t fare too badly either.

Credit for trade helps to solidify relationships for the long term. It gives both parties a reason to work together to find a solution.

What are the disadvantages of using trade credit?

  • The necessity of credit management
  • Possible incurrence of late payment fees
  • Possible complications with the supply chain
  • Could have an effect on creditworthiness
  • Some vendors might be unwilling to extend credit to new businesses.
  • If the due date for payment is missed, it can be expensive.
The most significant drawback associated with trade credit is the possibility of a knock-on effect occurring if things do not go according to plan. When it comes to buyers, the penalty for not holding up their end of the bargain can add to their costs and sour their relationship with the seller.

However, the situation may be much more dire for the suppliers. It is possible for the future of the supplier to be uncertain if the business of the customer fails and the debts are not paid.

What is Trade Credit Insurance?

Trade credit insurance protects your company against unpaid invoices and protects your accounts receivable in the event that a customer declares bankruptcy, defaults, experiences political risks, or for any other reason that has been agreed upon with your insurer. There are a few different names for trade credit insurance, including accounts receivable insurance, export credit insurance, and debtor insurance.

What exactly is covered by Trade Credit Insurance?

In certain circumstances, a default on debt can bring an entire company to its knees. Credit insurance is a type of insurance that protects a company against the risk of never being paid for services or goods that were provided on finance or receiving payments that are exorbitantly late. This type of risk can occur when a customer defaults on their payment obligations.

It is all too common for businesses to become insolvent, which occurs when a company is unable to pay its outstanding obligations. A credit insurance policy can provide a supplier with the peace of mind they need by ensuring that their business will not endure serious ramifications as a direct result of the cashflow problems encountered by another company. In other words, the policy protects the supplier from the adverse effects of the other company’s financial difficulties.

Credit insurance can also be helpful in protecting businesses from wider risks, such as changes in international trade or involvement by the government in a particular sector of a company’s market. Both of these types of risks can be detrimental to the company’s bottom line.

Trade credit costs

Trade credit does not have any direct costs like a bank loan does; however, there are indirect costs and a price that must be paid if something goes wrong. Consider the following, among other things:

  • If you pay your bill by the due date, the credit shouldn’t cost you any additional money at all.
  • If you don’t take advantage of the early payment discount, you are opting to pay more money so that the credit period can be extended for a longer period of time.
  • If you do not pay your invoices by the due date, you may be subject to a penalty fee.
  • It’s possible that you’ll require resources for managing your credit.
  • If you are frequently late with your payments, a supplier may decide to stop extending credit to you, alter the terms of their agreement with you, or refuse to do business with you altogether.

Using trade credit as a source of financing

The majority of companies recognise the significance of having access to trade credit. You should be aware, on the other hand, that trade credit is not a viable option for long-term financing for your business.

One of the model’s strengths is its repeatability, which makes it ideal for use in business credit transactions.

You begin by purchasing the goods, then you add value to them, sell them, and use the money you make to pay the invoice that was sent to you by your supplier.

Summary

Although trade credit can be a short-term financing option for your business, it shouldn’t be used as a long-term solution. You may be better off looking at a small business loan, company credit card, or even an extended overdraft.

Topic

Finance

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