Trade Credit Explained
With trade credit, businesses will come to an understanding to allow a trade of goods and/or services instead of immediate payment, which can be helpful if working capital is limited. However, the funds will eventually have to be paid back on whatever scheduled date or repayment schedule both parties agreed on. The World Trade Organization estimates between 80% and 90% of international trade relies on trade finance!
Trade credit is extremely important for small businesses, as it can help them establish growth without having capital upfront. Trade credit may mean a better purchase deal and an interest-free loan. But these advantages are just the tip of the iceberg when discussing trade credit financing. Here, you’ll learn more about the ins and outs of trade credit!
Understanding the Basics of Trade Credit
As mentioned above, trade credit is an understanding or agreement between two businesses (these businesses can also be consumers) where money isn’t needed upfront; instead, goods and services are exchanged, and a repayment option/plan is established for a future date.
Trade finance or trade credit works only when a business offers this financing, some places refrain from offering trade credit because of the potential risk that these options may come with. Another hindrance may be practicality—some businesses do not provide easily tangible/tradeable products. However, there are many businesses, both nationally and internationally, that do offer trade credit. Infact, in today’s world, trade credit is the second most popular form of small business financing.
Once the trade is made and the businesses enter into this agreement, usually, trade credit must be repaid in 7, 30, 60, 90, or 120 days after the loan agreement. Trade credit is typically short-term financing. However, that can be extended, and some lenders offer longer repayment terms.
One thing to remember with trade credit is that customers/businesses being offered the credit may be able to save money by making an early payment.
Difference Between Trade Credit and Loans
Although trade credit and loans are both forms of financing, there are some significant differences. With a standard installment loan, borrowers get the money right away that they will have to pay back in regular monthly installments. While with trade credits, there is no cash exchange right away, and repayment may work completely differently.
Where Does Trade Credit Come From?
Trade credit comes from the businesses or financial institutions that offer this funding and is made available through products or services. When it comes to paying back a trade credit, the company that was offered the borrowing will have to make the payment back. Regarding how trade credit is made available, there are a few different types.
Types of Trade Credit Financing
Here are some types of trade credit financing available:
Open Account Credit
The most common trade credit account type offered is open trade credit. With these, the only primary documentation usually involved is an invoice and a promissory note or IOU.
If you have taken out a standard loan, you are probably familiar with this kind of repayment. With installment loans or credit, the debtor will repay the trade credit in equal installments. What those installments will look like will depend on the agreement set forth.
Revolving Credit Lines
Traditional revolving credit accounts allow access to credit multiple times until a set credit limit is reached. Once a borrower makes payments, they will have available credit again and can use the account, and that cycle can repeat. Revolving trade credit may allow borrowers to have access to purchase goods or services for more than one time period.
Consignment credit is when one party provides goods (the cosigner) to another party (the consignee) for the purpose of having the goods sold. The products are provided at a lower cost than what they would sell at retail price, allowing the consignee to profit while the cosigner can also make a profit—as the products are marked up from production/labor costs. The consignee can then try and sell those goods and will have a certain amount of time before they can return any unsold goods to the cosigner.
Industries that Use Trade Credit
The majority of small businesses use systems of trade credit to finance their operational costs. According to the GetBalance, 40% of U.S businesses claimed their B2B transactions rely on trade credit for financing. Here is a list of different industries that commonly use trade credit:
- Construction companies
- Clothing retailers
- General retailers
- Landscaping companies
- Marketing companies
The Benefits of Trade Credit
As mentioned earlier, there are definitely benefits that can come with trade credit; here are some of the significant benefits for businesses/consumers who decide to pursue trade credit:
Improved Cash Flow
One of the major benefits that a business may gain from trade credit is an improvement in its cash flow. When paying cash for services or goods outright, a business must produce the funding amount immediately. However, with trade credit, because payment isn’t required right away, it can help with the company’s cash flow! This is so important for any business, especially small businesses that are just starting or are in a growth period.
Better Supplier Relationships
Another benefit to trade credit is that it can help build better supplier relationships. Depending on the type of business/trade, this can be essential for success! With trade credit transactions, business owners can build trust and help each other out, which can go a long way.
Opportunity to Build Credit
Business credit is essential for businesses to succeed! And a positive payment history with trade credit (as long as those payments are reported to one or more appropriate bureaus) can help build a credit history or improve a low score.
Purchasers who use trade credit may receive personalized discounts, especially after building a relationship through customer loyalty with their suppliers.
How To Establish Trade Credit
Have you never gone through the process of trade credit before? Here is a quick outline of what steps it may entail:
The First Step: Demonstrating Financial Stability
The first step of the process is to figure out the best way for a business to prove that it will make good on its promise to repay its debt. With traditional loans, most lenders will simply check out a borrower’s credit. However, trade credit may not always rely on that rating and may look at a few other factors for approval. Here are some standard strategies that businesses may use when trying to secure trade credit:
- Providing Financial Statements — Financial statements can vary quite a bit; they can be a bank statement or statements, invoices, letters of income, etc. The purpose of financial statements in this scenario is to show a lender that a business does have ongoing revenue and will be able to pay or make payments when their due date or dates.
- Offering Collateral or Personal Guarantees — To offset risk and improve approval chances, a business seeking trade credit can offer collateral or a personal guarantee. A personal guarantee adds a layer of protection for the lender; if the business cannot repay them, an individual will be responsible for repaying the loan.
The Second Step: Establishing Trade Credit Terms
Once a business gets through the approval process, it will have to work with the lender to establish credit and payment terms. Here, things like specific quantities or extent or services may be discussed. Along with establishing a timeline for repayment, there may be some discussion about discounts if the money owed is paid back early, along with what will happen if the debt is not repaid on time.
Essentially, all the ins and outs of the agreement will be ironed out and put into writing. Some businesses may use a third-party credit management system to save time with onboarding and underwriting. While others may have a credit manager in-house.
The Final Step: Begin Repayment
Once the time for repayment begins, all that is left to do is to make the payments as scheduled. If done on time, this may help build a great relationship between the parties involved and help the borrowing business establish better credit history and footing.
How to Manage Trade Credit
Once an agreement has been established and the products or services have been made available, it is up to both parties to manage the trade agreement. However, most of the burden will fall on the debtor since, by the end, all that is left to do is repay. Here are some tips for borrowers that may help ensure a smooth repayment process.
- Paying Bills on Time — Paying all bills on time, including this debt, is essential. By making sure the rest of their finances look good, a business improves its chances of ensuring repayment for their trade credit runs smoothly.
- Managing Cash Flow — Cash flow is essential for a business, and when in debt (debt that will likely have to be repaid quickly), it is crucial to ensure that there is enough cash available for when the time comes for loan repayment.
The Risks of Trade Credit
There are definitely risks for both the borrower and lender with trade credit. However, the risk for the lender may be higher. This is one reason why some businesses do not offer trade credits at all. Nonetheless, here are some risks to consider before jumping into trade credit; (these focus on the borrower’s end).
- Damage to the Buyer’s Credit Rating — Missing a due date or making late payments may damage the borrowing company’s credit rating. This can turn a business with a good credit rating into one that is seen as a credit risk, making it difficult to secure financing in the future. Late payments can also mean actually having to pay interest on an otherwise interest-free loan and late fees.
- Strained Supplier Relationships — Missing a payment date or having a late payment can sour the relationship between businesses and may not mean discounts or the ability to work together in the future, regardless of how many new customers or existing customers the supplier already has.
Trade Credit Insurance
Trade credit insurance policy, or sometimes called accounts receivable insurance, is a tool that helps with risk management. This insurance protects suppliers from bad debts. Bad debts are considered any lending choices leading to losses, typically on the borrower’s end.. Along with protection against bad debt, this insurance protects accounts receivable from unpaid invoices due to customer default, political risk (which can occur with international trade), bankruptcy, and anything else in the insurance policy. Like any insurance policy, finding one that fits your needs is important. Additionally, knowing what kind of coverage a business has before taking risks is critical, as many policies may not cover everything.
Trade credit insurance works essentially as a form of business financing, primarily operating in a business-to-business realm. Instead of a business paying upfront for goods and services, the supplier may allow them to repay the funds at a later date. When taking on this form of business financing, it is important for both parties to manage the debt wisely and follow the agreed-upon contract.