Trade credit is an arrangement that allows a business to acquire goods or services from another business without making an immediate payment. This ability to buy now and pay later is an important financing tool for businesses, especially those too new or small to obtain bank loans. Trade credit is essentially a short-term loan without interest. When discounts for faster payment and penalties for late payments are taken into consideration, however, trade credit can still cost the buyer more than other kinds of financing.
Who Uses Trade Credit?
Trade credit is the only kind of financing used by about 20% of small businesses, according to Surveys of Small Business Finances by the Small Business Administration. Another 40% of small firms use a combination of trade credit and bank credit. Small businesses may use this form of financing more often when credit markets are tight and bank loan approvals are more difficult to obtain. Service firms use less trade credit than other types of businesses, according to the SBA.
Trade Credit Terms
When a buyer makes a purchase using trade credit, ordinarily there is no loan agreement. The seller sends an invoice along with the products that are being delivered. The invoice will describe the terms of payment. The terms generally call for payment in full within 30, 60 or 90 days. Sometimes there is a shorter period, such as seven days, or a longer period, up to 120 days.
In addition to specifying paying by a certain date, the trade credit terms also generally offer a discount if the customer pays sooner. For instance, the trade credit agreement may call for payment in full within 30 days. However, by paying within 10 days of the invoice or delivery date, the customer may get a discount of 4%.
Pros and Cons of Trade Credit
Businesses that use trade credit to close sales to retailers are able to expand without borrowing. Trade credit allows sellers that offer this form of financing to increase their sales. However, from the provider of trade credit’s perspective, allowing customers to buy now and pay later effectively reduces the price they receive.
When a seller offers a discount for early payment, it can encourage faster payment of invoices and reduce the need for working capital. However, depending on the discount it can be more expensive than taking a bank loan.
Not all buyers are able to acquire goods and services using trade credit. Sellers may require their customers to have a previous history of purchasing and paying on delivery before they offer trade credit. Sellers may also want trade credit customers to demonstrate adequate financial strength, by providing sellers with copies of financial statements, before offering trade credit terms.
Customers who don’t qualify for trade credit may be required to pay with a credit card or with a check or cash on delivery (C.O.D.) Additionally, if a customer is provided with trade credit and then doesn’t pay on time, the seller may limit the customer to C.O.D. terms from that point on.
From the seller’s standpoint, offering trade credit also means shouldering some additional risk. Buyers may not always pay on time or at all after taking delivery of goods. Sellers that offer trade credit may, however, get some additional income from late fees and delinquency penalties charged to customers who do pay for their orders after the due date. From the buyer’s perspective, the added fees and penalties of paying late can add up to more than the cost of borrowing to make the purchase.
The Bottom Line
New businesses often have difficulty getting trade credit from their suppliers before they have a history of paying on time. Start-up owners may be able to convince suppliers to offer them credit terms if they share their financial plans and can show adequate financial resources to make good on their orders.
Trade credit lets businesses buy now and pay later without taking out a loan. It’s an important financing tool, especially for smaller and newer businesses. Sellers can increase their sales, at the cost of receiving an effectively lower price for their goods, by offering customers trade credit. Not all buyers can qualify for trade credit, and those that can’t are required to pay C.O.D.
Tips for Business Owners
- Consider working with an experienced financial advisor if you are considering selling or buying goods using trade credit. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you need funding for your small business, you might be able to find a foundation, a nonprofit or a special program that’s willing to offer you a grant. Another option for grants is the Small Business Administration.
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