Explore the advantages and disadvantages of trade credit.
Advantages & Disadvantages of Trade Credit
Most businesses need short-term finance to operate, accessing goods before payment is made.
One type of short-term business finance is trade credit, allowing a business to receive goods that can then be sold in their business before paying the supplier for the goods received.
However, there are risks associated with trade credit for both the business receiving the goods on finance and the supplier giving the credit.
In this article, we’ll explore the advantages and disadvantages of trade credit, looking at this line of credit from the perspective of the business customer as well as the supplier.
What Is Trade Credit?
‘Trade credit’ refers to an agreement made in the business industry where a business receives goods but pays the supplier for them at a later date. This is a line of credit used for short-term borrowing.
Many businesses use trade credit to their advantage as they can sell their products and services before paying the supplier the money owed. This can help a business to generate revenue before paying for the goods supplied.
How Does Trade Credit Work?
Trade credit enables a supplier to provide goods at no cost to a business. The business will then sell those goods in their own business. Their customers will buy the goods and pay the necessary price.
The business will pay the supplier’s invoice within the necessary payment date. The supplier will then receive payment for the goods originally sent to the business.
When Are Suppliers Paid?
The supplier will allow a set number of days before the business must pay for the goods. This may be 30 days, or up to 90 days, depending on the terms and conditions of the trade credit.
Do Suppliers Charge Interest on Trade Credit?
Usually, trade credit is a 0% interest line of credit. This means that most suppliers will not add interest to the money you owe them when using trade credit for your business.
However, some suppliers may charge interest on trade credit. Any interest payable will be added to the money owed, requiring that you pay for the whole outstanding balance in one payment.
Sometimes, a supplier may charge trade credit interest for new business customers, particularly if you have a poor credit history. However, ensure that any interest added to the trade credit agreement is clear before you accept.
What if You Fail to Pay a Trade Credit Supplier?
Failing to pay a trade credit supplier can result in fees being charged. As well as increasing your costs, this also negatively impacts your business and damages your relationship with the supplier.
The supplier may not allow you to have trade credit in the future if you have failed to pay on time previously. Your reputation may also be damaged with other suppliers, preventing access to other lines of finance.
Additionally, you could be charged interest if you fail to pay the trade credit balance over time. This will result in substantial additional costs for your business and damage to your credit score.
Do Suppliers Allow Trade Credit Discounts?
Sometimes, a supplier may offer a discount on the trade credit balance if you make a payment earlier than required. For example, the supplier could allow you 90 days to pay your trade credit balance, but offer a 5% discount if you pay within 10 days.
Offering discounts for early payments benefits both the business customer and the supplier. The business customer receives a discount whilst the supplier receives payment and improves their cash flow much sooner than expected.
Trade Credit Pros and Cons
Trade credit as a line of finance can offer various pros and cons to your business.
Here are the top pros and cons to consider:
- Straightforward to access — Trade credit agreements can be straightforward to put in place. Trade credit does not require the same stringent credit checks as required by business loans and may be easier to access.
- A regular line of credit — As long as you pay your trade credit bill on time, you should be able to access trade credit as a line of credit regularly.
- 0% interest — Many suppliers will offer trade credit with 0% interest to entice business customers, ensuring that you only pay for the goods received.
- Discounts — Some suppliers offer discounts for early repayments or for regular custom. You could also receive a discount if you bulk buy large orders.
- No guarantees — If your own customers do not pay you on time, you may not be able to pay the suppliers on time. There are no guarantees in business.
- Not suitable for all businesses — Some businesses are not suited to the trade credit line of finance model. Whether your business is suited to the trade credit line of finance will depend on the nature of your business.
- Overtrading — An easy line of credit may encourage your business to overtrade and order more goods than needed. You could be left with large volumes of remaining stock that will not be sold but that still need to be paid for.
- Costs — A supplier may increase the cost of goods available for trade credit, subtly covering their own financial risk. This could lower your potential profits from selling those goods in your business so ensure to work out whether the supplier costs are reasonable.
What Are the Advantages of Trade Credit for Your Business?
Trade credit advantages are prevalent for start-up businesses or businesses that have not yet secured a business loan or funds from business credit cards. Here are the main advantages of using trade credit for your business:
1. Easy to Set Up
Almost all suppliers offer trade credit and require that you complete a simple application form. The process is much more informal than when you apply for business start-up loans or other lines of credit.
2. Frees Up Working Capital
You can access goods to sell to your customers and pay the supplier at a later date once you have generated revenue. This ensures a healthy business bank account. You can start operating your business without paying upfront for goods from the supplier, improving your cash flow from your first day of trading.
3. Discounts for Early Payment
Paying your trade credit bill before the required payment date may result in a discount, saving you money. This will vary from supplier to supplier, however.
4. Fuels Growth
Trade credit helps your business to grow so you can focus on making sales and generating revenue whilst paying the supplier bill later.
Many suppliers will offer 0% interest on trade credit balances, providing an interest-free loan through trade finance. This means that you will only pay for the goods you received and no additional charges. Some suppliers may charge an interest rate, although it is usually a low amount.
5. Helps Cash Flow
Your cash flow is the money that flows into your business and that flows out of your business. When considering your cash flow, trade credit delays some of the money flowing out of your business, helping to temporarily improve the cash flow in your business. This is especially important for business startups.
6. Building Relationships
Many aspects of business rely on strong relationships. For example, your business will want loyal, returning customers, whilst your supplier will want repeated custom and on-time payments.
Trade credit helps to build relationships between your business and your supplier, as long as you pay your trade credit balance on time. Eventually, you may be able to increase your trade credit limit or extend the payment date due to the trust that has developed.
What Are the Disadvantages of Trade Credit for Your Business?
Using trade credit in your business does offer some risks that you must consider.
Here are the main disadvantages of using trade credit for your business:
1. Increased Costs
Depending on the supplier used, you could face paying a higher cost for goods in comparison to paying upfront. Increased costs may not be obvious so you must be aware of all costs before agreeing to trade credit terms.
If you can afford to pay outright for the goods you need, you could save money doing so.
2. Missed Payment Dates
If you miss a payment date for trade credit payments, you could be charged a late payment fee or interest on the outstanding balance. This will increase your costs immediately and heighten your payment difficulties.
3. Poor Credit Rating
Missed payment dates and paying fees and interests, as a result, may negatively impact your credit rating. A lower credit score may then prevent you from accessing other sources of finance for your business, limiting your potential opportunities.
4. Damaged Relationships
A further impact of missing trade credit payment dates is the damage caused to your business relationships. Understandably, the supplier may not trust that you will pay on time in the future and may not offer your trade credit again.
Other suppliers may hear about your reputation and also rescind any trade credit agreement offers. This could result in a lack of suppliers willing to supply you with goods.
What Are the Advantages of Trade Credit for Suppliers?
When a supplier offers a business trade credit, there are several advantages for their own business.
Here are the main advantages of a supplier giving trade credit to businesses:
1. Attract New Customers
A supplier needs business customers and so offering trade credit to new customers is an attractive proposition. New business customers will want to look for a supplier who can help them in their own business.
Therefore, offering trade credit is a key method to help customers improve their cash flow and business growth, enabling them to buy now and pay later.
2. Increased Sales
Offering business customers trade credit increases your own sales overtime. Enticing customers further with bulk buying and discounts can increase your sales even further.
3. Good Relationships
Trade credit can help to build good relationships between suppliers and business customers, as long as payments are made on time. This can result in further advantages and opportunities across the industry.
What Are the Disadvantages of Trade Credit for Suppliers?
Trade credit is a risk for suppliers.
Here are the main disadvantages of a supplier giving trade credit to businesses:
1. Missed Payments
If a business customer misses a payment, this can have serious repercussions for the supplier and their own finances, negatively impacting their cash flow. The supplier could also lose confidence that the business customer will pay their bill at all in the future.
2. Bad Debt
If a business customer does not pay at all, the supplier will need to write off the loss and this will become a bad debt. The supplier will need to cover the costs unless trade credit insurance is purchased and complied with. Trade credit insurance may help to recoup some of the bad debt incurred.
Trade credit facilities can help to increase the cash flow of the business, enabling you to access short-term finance at much lower rates than business bank loans.
As long as you pay your trade credit payments on time, trade credit can be a good source of finance for your business to access regularly, as well as help to improve your credit rating.
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