Trade Credit: How It Works for Buyers and Suppliers (2024)

Managing cash flow for major business expenses like inventory or raw materials can be challenging. That’s where trade credit comes in—it allows you to spread out payments over time rather than paying upfront. Here’s a breakdown of how it works and how it benefits both buyers and suppliers.

What is trade credit?

Trade credit is essentially a short-term financing agreement between a buyer and a supplier. If you’ve heard the term “net terms,” you’re familiar with trade credit, even if you didn’t know it by name. It’s a simple concept: the supplier gives the buyer time to pay after receiving goods or services. For example, “net 30” means you have 30 business days to pay.

Trade credit is often easier to obtain compared to formal loans because it doesn’t require a detailed application process. It’s especially crucial for small and medium-sized businesses that may struggle to secure traditional financing.

Also read: How to Get a Startup Business Loan: A Complete Guide

What is trade credit used for?

Trade credit is used to facilitate the purchase of large goods and service contracts. (Even smaller purchases, too, depending on the relationships in place with suppliers.) With trade credit, businesses can purchase what they need at once and stagger repayment across vendors.

Also, implemented intelligently on the part of the buyer, trade credit also gives businesses the flexibility to make sure that they will have enough money to cover all of their trade credit bills on time.

Advantages of trade credit

For buyers

  • More time to pay. It’s hard to come up with the money you need to pay for major purchases all at once. Trade credit extends your window of payment from COD (cash or collect on delivery) to the terms you and your supplier agree on.
  • Build business credit. Trade lines of credit help you establish business credit. Some major credit bureaus take trade credit into account when calculating business credit scores.
  • Potential discounts. Many suppliers will offer small discounts to incentivize buyers to pay before their due date. You might be able to save money if you can pay before your bill comes due.

For suppliers

  • Open up more relationships. The vast majority of buyers rely on trade credit for large purchases. Offering this financing for buyers can open up new relationships and potentially larger purchases with existing ones.
  • Becoming a preferred supplier. Customers may favor you if they’re able to negotiate favorable trade credit terms with you that aren’t available through competitors.

Drawbacks of trade credit

For buyers

  • Potential discount loss. This is more opportunity cost than anything. Still, if you wait to pay your invoice until its due date, you forego any potential discount the supplier might offer if you pay upfront in cash.
  • Relationship risk. If you aren’t able to pay on your bill for services rendered or goods received, you risk putting your relationship with your vendor in jeopardy.

For suppliers

  • Risk of delinquency. When you extend trade credit, there’s no guarantee that you’ll get your payment on time — or at all. And although you’ll only extend trade credit to the customers you trust, you’re still taking a gamble on their business.
  • Discounting. In order to incentivize your customers to pay before their terms come due, you might have to offer some form of discounting for early payment. This will cut into your margins.
  • Uneven cash flow. The nature of trade credit means you don’t know when your customers will pay. This creates an inherently uneven, unpredictable cash flow. While you want to be flexible, you also want to set terms that favor your business as well.

How trade credit affects cash flow

You’ve likely figured out by now that there’s a very direct tie into trade credit and cash flow. That goes regardless of which side of the terms you’re on.

As a customer

  • You’ll be able to plan your invoice payment based on your cash flow projections.
  • You don’t have to pay COD or pay for everything at once if you don’t have the cash on hand for it.
  • You can stagger payments across multiple lines based on available cash flow.
  • You can take advantage of discounts if you have the available liquidity and know that paying in full early won’t affect your working capital.

As a supplier

  • You might introduce an element of unpredictability into your accruals depending on when your customers actually pay.
  • You introduce the possibility of late or non-payment after services are rendered or goods are delivered.
  • You might want to take advantage of invoice factoring to access cash tied up in trade credit.

Also read:

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Trade Credit: How It Works for Buyers and Suppliers (2024)

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