The Small Business Owner’s Guide to Trade Credit

When you think through different options for business funding, your subconscious might instinctively start bracing itself for a trip to the local bank, complete with an overwhelming stack of paperwork.

Turning to Google, you quickly find yourself researching loan opportunities from online alternative lenders. You might even consider using a credit card to finance your most immediate business expenses.

But have you considered that funding the purchase of inventory or supplies for your business might not need to be that complicated?

If your business routinely places bulk orders with an outside vendor for raw materials, stock inventory, small equipment, or even office supplies, the best place to find funding for those purchases may actually be from the vendors themselves.

As it turns out, this financing arrangement—called trade credit—is far more common than you might expect.

What Is Trade Credit?

Simply put, trade credit is any arrangement in which a customer can order and receive goods or services now to be paid for at a mutually agreed-upon later date—typically 30, 45, 60, or 90 days in the future.

Also sometimes called placing an order on account, this informal credit relationship between vendor and customer is a great way for small businesses to order inventory or raw materials for resale without having to immediately outlay the cost of the goods.

As an example, let’s imagine you’re starting a business that designs, prints, and sells custom graphic t-shirts. To produce that product, you have to purchase an initial inventory of solid colored t-shirts on which to print your designs, along with screen-printing equipment and supplies. Before you can generate revenue on that product, you need to first obtain the supplies, print your t-shirts, and sell them, right? So you need money now to buy supplies, but you won’t have made any money from your business until a little while later.

You could invest your own money into purchasing your initial t-shirt inventory, borrow funds from a friend or family member, or obtain a short-term loan from a bank or online lender.

Or you could find a t-shirt vendor that would agree to send you an initial inventory of t-shirts now with the understanding that you’ll pay for your order within 30 or 60 days—enough time to print and sell your t-shirts to generate revenue, some of which will go toward paying the vendor.

That last option is a classic example of trade credit.

Understanding Invoicing Terms

Although trade credit is a form of debt, the agreement between vendor and customer in a trade credit arrangement is typically much less formal than a traditional lender and borrower relationship.

Some wise lenders do require credit checks for new customer accounts, but most do not—and often the invoice itself is the only indication of a credit relationship.

When you negotiate a trade credit arrangement with a vendor, the terms of that relationship should be indicated on your order invoice. This includes the due date of payment, along with any late penalties or discounts for prompt payment.

Since your invoice is effectively a loan agreement between supplier and customer, let’s quickly review some common invoicing terms you may encounter.

Cash-based invoicing: Anytime a vendor expects payment for an order before or at the time a product is delivered or service is performed, that is an example of cash-based invoicing. Here are some common terms you might see on a vendor’s website, in a contract, or printed on the invoice indicating that they traditionally operate on a cash-based invoicing system:

• Paid in advance: Payment must be submitted before the order will be shipped.
• Cash on delivery: Payment is due in cash at the time that the order is delivered.
• Due on receipt: Payment is due immediately upon receipt of invoice.

In each of these cases, payment for an order is due either before the order can be shipped or immediately after the order is delivered. Along with companies that issue invoices with these terms, any vendor from whom you purchase items in a point-of-sale fashion—either with cash or on a business credit card—is also effectively using cash-based invoicing.

Trade credit invoicing: Invoices issued on trade credit are typically issued as “net” followed by the number of days from issue that trade credit is extended. This is based on days from date of invoice, and both the invoice date and the payment due date are listed on the invoice. For example, you might see one of the following terms on an invoice with trade credit.

• Net 30: Payment due within 30 days of invoice date.
• Net 45: Payment due within 45 days of invoice date.
• Net 60: Payment due within 60 days of invoice date.

Many vendors default to net 30 invoicing terms, meaning you don’t even have to negotiate for trade credit.

Even so, it’s a good idea to ask about any new vendor’s standard invoicing terms before placing your first order so that you can discuss a trade credit agreement if needed.

The Cost of Trade Credit

Most trade credit agreements aren’t interest bearing in the traditional sense, but that doesn’t mean that purchasing goods or services on trade credit comes without cost. If you pay attention to your vendor’s invoice terms, you’ll find the saying holds true that “there’s no such thing as a free lunch.”

Let’s take a look at the two most common methods that vendors use to protect their cash flow when extending trade credit to customers. From your perspective as a potential customer, these are costs of doing business on trade credit—not unlike the cost of interest on a loan.

Cash or Prompt Payment Discounts

To improve cash flow and shore up their own cash on hand, vendors that routinely issue net 30 or net 45 invoices on trade credit sometimes include in their terms a percentage discount for cash on delivery or prompt payment of invoices. This could include terms such as a 5% discount on invoices paid within 10 days of issue, for example.

It sounds like a dream scenario, right?

Your vendor is willing not only to extend trade credit on the order you placed but is even discounting your order if you can pay earlier than requested! But let’s stop and think about this for a minute, because the term discount in this context is a bit deceiving.

Remember, the vendor is the one setting the prices on their merchandise in the first place. They chose that price that they’re discounting from, most likely by determining a cash price, then increasing that price by the amount of their posted prompt payment discount to set a net 30, 45, or 60 day price. In reality, the “prompt payment discount” or cash price is the real price of the goods, and the amount of the discount is actually your cost of using trade credit.

This difference might sound like semantics, but it should create an important distinction in your mindset as you purchase goods from a vendor on trade credit. No matter the circumstances or the vocabulary used, trade credit is a form of debt—and debt always has a cost.

Late Payment Penalties

A single cash flow scare caused by late-paying customers is usually all it takes for vendors to wise up to the importance of including late payment penalties in their invoicing terms.

In fact, some accounting professionals would suggest that if your invoice doesn’t include a late payment penalty, it doesn’t really have a due date!

As a result, it is not at all uncommon to see invoices from vendors that include a 10% or even 15% penalty charged on all overdue invoices. Some accounting software even offers settings that implement those penalties on past due invoices automatically.

Of course, it goes without saying that you want to avoid late payments at all cost—not only because of the hefty penalty or the fact that paying late might damage your relationship with your vendor—but depending on the vendor’s credit reporting policies, a history of late payments could make its way to your business credit report and jeopardize future financing opportunities for your business. Yikes!

We talk more about accounts payable practices below.

But for now, here’s our best advice.

If ever you find yourself in a position where you might be forced to pay a vendor after the invoice due date, always contact the vendor in advance to explain the situation. Suppliers are far more likely to show understanding if you let them know what’s going on and offer a solution.

6 Tips and Tricks for Purchasing on Trade Credit

While trade credit can be available to businesses with nothing more than a single phone call or handshake, using trade credit to your business’s advantage is easier to achieve if you know what steps to take.

Follow these simple tips to enjoy the best of what trade credit can offer your business without backing yourself into a cash flow corner.

1. Look to smaller vendors for better terms

Large vendors can sometimes be hesitant to extend trade credit to younger businesses or first-time customers, and those that do might include a hefty upcharge for longer payment terms. If you’re having trouble finding trade credit with terms you can afford, shop around for a smaller vendor with whom you can negotiate directly.

Being able to form a business-owner-to-business-owner relationship with a smaller vendor increases your chances of coming to an agreement that will meet your needs. And as a fellow small business owner, that vendor turned friend is much more likely to respond compassionately in the future if a cash flow bind forces you to make a one-off late payment.

2. Don’t place orders too early

For small business owners, the greatest benefit of trade credit is the opportunity to greatly reduce or even eliminate the dip in cash flow between when you purchase inventory or supplies from a wholesaler and when you can make up that expense with sales revenue. Taking advantage of that opportunity, however, requires diligence to make sure that you don’t place orders earlier than necessary.

To better illustrate this issue, let’s look back to our imagined t-shirt designing business. Ideally, we would want to finalize the designs before we order the shirts from our vendor, place the order, and then take any necessary steps to prepare the designs for printing while the unprinted t-shirts ship. That way, when the order arrives from our vendor, we’re ready to immediately print and sell our designed t-shirts in order to pay the vendor’s invoice as quickly as possible.

When you’re relying on trade credit that comes with early payment discounts or interest-bearing terms, every day that you hold onto unused raw materials or unsold inventory is costing your business money.

Keep an eye on your inventory management process, and look for bottlenecks that could be adjusted to reduce your trade credit costs.

3. Choose order quantities conservatively

When you’re purchasing inventory or supplies on trade credit, accurately projecting your sales volume is critical. Even if your vendor offers a discounted cost for larger quantity orders, being overly eager in your sales estimates can get you into a lot of trouble, and fast.

As a rule of thumb, you’re much better off starting with a small order and selling out of a particular product for a few days than being left with a pile of sitting inventory and no way to pay your supplier.

Talk to your supplier or manufacturer about the lead time needed to turn around new orders, and make a plan for how you’ll proceed if a product comes close to selling out.

And remember to let customers know when you have limited quantities of a particular product! This knowledge can help trigger a sale from your on-the-fence potential buyers.

4. Encourage customer pre-ordering

Have you ever noticed that Amazon begins selling pre-orders of your favorite author’s next title months before it’s released, often in exchange for a discount, preview chapter, or some other added benefit?

This relatively common practice is a great way to increase the buzz around a new book title, but that’s not the only benefit. When you pre-order a new title, you’re actually helping the publisher pay for the printing of the title—and your decision to pre-order (or not) helps them decide how many copies of the book they should print ahead of the release.

This pre-ordering model is a great option for small consumer-driven businesses with seasonal or highly anticipated merchandise. If you have a small base of loyal customers who eagerly await the products you create, consider offering pre-orders to help you more accurately estimate sales.

You can use pre-order volumes to better anticipate the popularity of different products while using pre-order revenue to take advantage of early payment discounts from your vendors.

5. Keep a reserve of cash on hand

Despite your best efforts to encourage pre-orders, accurately estimate sales, and turn inventory around quickly, it’s almost inevitable that at some point over the life of your business, your trade credit formula will go awry.

This is particularly true for B2B entrepreneurs who use trade credit with their suppliers while also extending trade credit to their customers, as one late-paying customer can quickly create a domino effect.

Smart business owners prepare for this eventuality by keeping a reserve of cash on hand large enough to cover at least one month’s supply of accounts payable—including payments on trade credit.

This requires having the diligence and the self-control to truly keep the funding untouched and reserved for a cash flow crisis, even if that means foregoing an early payment discount or some other tempting opportunity here or there.

6. Organize accounts payable to minimize costs

More than anything else, the key to maximizing the benefits and minimizing the costs of your trade credit arrangements comes down to wisely managing your business’s accounts payable—that is, the method by which your business pays its bills.

Now, we realize that of all the things on your entrepreneur to do list, this one probably ranks as the least exciting—but consider this: By streamlining your accounts payable process to pay bills in order of due date, maximize early payment discounts, and minimize late payment penalties, you could actually uncover thousands of dollars per year in hidden savings. Suddenly, accounts payable sounds a lot more interesting!

If you have yet to set up an organized accounts payable process for your business, check out our detailed accounts payable guide. It’s full of useful tips, tricks, and tools that make this part of business ownership a whole lot easier.

When Trade Credit Won’t Work

For easy access to very short-term funding of inventory or supplies, you’ve probably figured out by now that making a trade credit arrangement directly with your vendor is likely your best option.

However, trade credit isn’t designed to meet all of your business’s funding needs.

Circling back one more time to our (now highly successful, of course!) graphic t-shirt business, we saw that trade credit was a great way to finance the solid t-shirts we needed for printing our designs.

By streamlining our production process and placing orders at the right time, we could easily order our shirts, receive the shipment, screenprint our designs, and sell most of the inventory to customers in plenty of time to turn around the vendor’s invoice payment before the net 30 deadline.

But what about the screen printing equipment we would need to actually produce our shirt designs? The sales revenue from our first round of t-shirt sales surely wouldn’t be enough to cover the cost of such heavy and expensive machinery.

Maybe the equipment manufacturer would agree to a longer term trade credit arrangement—but since our business is brand-new, they might be more reticent to do so. We might have to seek outside equipment financing or apply for a term loan or line of credit from a bank or online lender to cover other business costs while we’re working to turn a profit.

Extending Trade Credit to Customers

If you operate a small B2B business, you might find yourself at both the customer and the vendor end of the B2B equation.

Just as trade credit helps you better manage your cash flow as a customer, this arrangement can be hugely beneficial to your customers, making them more likely to choose you as their primary vendor.

That said, extending trade credit to your customers does come with a certain level of risk, as late-paying customers are a chronic business reality. Before entering into a trade credit agreement with any customer, consider whether the following recommendations could help you to get paid in a timely manner.

Checking Customer Credit

Not all B2B vendors check new customers’ credit before entering into a trade credit relationship. But particularly when you’re considering a very large account, it’s a good idea to do so.

Most of the time, late-paying customers aren’t behind on payments with just one vendor, meaning they have a well-documented history of paying late. With business credit checks available from agencies like Dun & Bradstreet for as little as $90, this upfront cost is well worth it to avoid fronting thousands of dollars worth of work or supplies for a customer who is never going to pay.

Setting Your Invoicing Terms

Just as we discussed above from a customer perspective, setting clear invoicing terms, payment guidelines, and late payment penalties is critical to making sure that your customers make their payments on time, every time. Make sure that customers know when payments are due, and that penalties for failure to follow those policies are enforced.

Using preset templates, your accounting software can even help you automate payment reminders and late payment penalty notifications to help you get paid faster even while avoiding awkward personal conversations with your customers.

Invoice Financing for Cash Flow Emergencies

No matter how cautious or diligent you may be, the near inevitability of late paying customers in the B2B sector means that you might eventually end up in a cash flow bind. That domino effect can quickly lead to you missing payments with your vendors, which is exactly why late payments are so common between B2B suppliers and their customers.

If you’re at risk of a customer’s late payments becoming your cash flow emergency, consider invoice financing as an option to cover your immediate expenses.

Invoice financing can give you immediate access to up to 85% of your invoices’ value, with the other 10%-15% held in reserve until your customers pay their invoices.

Accounts receivable factoring is an expensive solution, but it might be worth the cost to avoid a cash flow crisis.

Do You Need Trade Credit Insurance?

For businesses that routinely extend trade credit to relatively high-risk buyers, the cost of invoice financing can add up quickly. As an alternative, some risk managers encourage purchasing trade credit insurance to protect against unpaid orders.

Trade credit insurance is most often recommended for businesses that deal in exports to other countries, since distance, changes in political climate, and more complex legal structures make it more likely that some customers won’t pay. If you’re primarily extending credit to local customers with whom you have an established relationship, trade credit insurance probably isn’t worth the expense.

Whether you’re extending trade credit to your own customers or seeking arrangement with vendors as a purchasing tool, this form of financing is an ideal solution for business owners who want the benefits of short-term financing without the costs or complications of working with a lender. Make sure you follow proper procedures and respect your vendors’ terms in order to enjoy the benefits of this funding solution throughout the life of your business!

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from Fundera Ledger https://www.fundera.com/blog/trade-credit