What is trade credit and why is it considered external finance?
Trade credit is an agreement where suppliers allow businesses to purchase goods or services and pay later. Since trade credit is extended by an external party (the supplier, who acts similarly to a bank) rather than being financed through a company’s own resources, it’s classified as external finance.
That makes it different to something like retained earnings or personal investment, which are internal sources of funding. Accordingly, trade credit creates a debt (also known as a liability) that has to be settled within the agreed timeframe.
The length of the arrangement is set by the agreed payment terms, which usually state that the debt be settled within 30, 60, or 90 days.
Many businesses use trade credit as a short-term financing solution, like a short term loan from the seller to the buyer, that lets businesses secure stock or materials without having to pay for it right away.
Example: how trade credit works
Say you’re a small retail business that needs to buy inventory for the upcoming busy season in summer. Instead of paying upfront, the supplier offers 60-day credit terms. The business can sell the inventory, generating revenue and repaying their supplier while still making a profit.
How does trade credit differ from internal funding?
Businesses fund themselves in all kinds of ways – this is known as internal funding, such as retained profits which involves reinvesting earnings back into the business. The assets of the business increase without any external party providing the resources.
Internal funding grows available liquidity without debt but is, naturally, limited by how much profit the business has available. Trade credit, on the other hand, allows companies to access resources immediately while deferring payment, creating extra liquidity beyond the cash immediately available.
The choice of which to use is a strategic question. If you’re looking to grow quickly, you may be happy to take the slight risk of taking on debt via trade credit, using B2B instalment payments to earn more now, and then repay later. On the other hand, if you’re happy to grow within your resources, you can rely on retained and invested profits to grow at your own pace.
Standard trade credit terms: what can you expect?
Trade credit is usually offered on set terms – instead of negotiating unique, tailored terms for each client, B2B sellers will work in multiples of 30 days, according to their risk tolerance or client profile. These are named accordingly:
- Net 30: payment due within 30 days
- Net 60: payment due within 60 days
- Net 90: payment due within 90 days
These can be complicated slightly if the supplier offers early payment discounts, adding a few extra letters to the term name. For example, a 2/10 Net 30 means that a 2% discount applies if payment is made within 10 days.
In general, the better your credit, supplier relationships and payment history, the better the terms you can negotiate with your suppliers.
Are there hidden costs or risks in using trade credit?
Costs with trade credit are minimal – unlike a loan from a bank, trade credit usually doesn’t include interest, so you only need to pay back the value of the goods purchased, without extra charges. The risks can come if you miss a payment or overextend yourself on credit arrangements, say by taking on too many payments.
This can lead to:
- Late payment penalties: Missing a payment due date can lead to suppliers charging interest on outstanding payments.
- Supplier relationship issues: Not sticking to a trade credit agreement can damage your sellers’ trust, limiting your options for suppliers.
- Higher supplier costs: Some suppliers adjust pricing to account for trade credit risk, meaning customers who pay upfront might receive better rates.
- Cash flow pressure: If you take on multiple trade credit agreements and multiple invoices come due at the same time, you might struggle to make payments without additional financing.
For example, say you order stock on a 60-day credit term but then end up with a slow sales period. When payment is due, you might not have enough cash on hand and end up incurring late fees, increasing your debt and reducing the likelihood the supplier will offer credit in future.
How does trade credit affect short-term liquidity?
Trade credit can improve liquidity by reducing the amount you have to pay upfront for key supplies, which leaves you with additional working capital to invest in other areas.. However, if you don’t manage your trade credit carefully, it can lead to a build up on debt and damage your financial reputation.
To keep trade credit working in your favor:
- Monitor and pay outstanding invoices regularly.
- Align your credit terms with customer payment cycles.
- Use a range of financing sources to avoid an overreliance on credit.
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How does trade credit fit into my overall financing strategy compared to loans, overdrafts, or equity
Trade credit isn’t the only external financing tool available. While it offers flexibility and easy access to goods or services without paying upfront, it’s not always the best solution for every scenario, and most businesses will use a mix of products, including bank loans, overdrafts, credit cards and equity financing.
- Trade credit: Used to source goods or services without paying straight away which is great for managing short-term cash flow. However, repayment terms are typically quite short and suppliers can impose credit limits that limit your flexibility.
- Bank loans: Small business loans provide access to larger sums of money with structured repayment plans, which are useful for long-term investments or expansion efforts.
- Business overdrafts: These offer quick access to additional funds, providing a safety net for short-term cash flow fluctuations, but they often come with high-interest rates and require bank approval.
- Equity financing: Usually used by fast growing businesses, equity is a way to secure capital without a traditional repayment structure. However, it also involves relinquishing a portion of ownership and potentially sharing future profits with investors.
Like all forms of credit, using trade credit effectively requires matching it to the right use case. When it comes to maintaining inventory levels or creating flexibility in your accounts payable process, trade credit can help manage your short-term finances flexibly to prioritise spending on the go.
Should I offer trade credit or BNPL to my B2B customers?
If you sell to other businesses, offering trade credit or B2B Buy Now, Pay Later (BNPL) is a powerful way to increase sales and improve customer loyalty by providing more flexibility in when and how customers pay.
However, trade credit and B2B BNPL have some key differences. Trade credit covers all instances of offering credit to a customer to extend their payments terms and forgo immediate settlement to help them manage their cash flow. In standard trade credit arrangements, the seller takes responsibility for checking customer creditworthiness, chasing repayments and holding the debt on their own books.
B2B BNPL uses an intermediate credit provider to smooth the process. The BNPL partner, such as iwocaPay, takes responsibility for vetting and approving customers, paying the seller immediately and managing the ongoing repayments of the credit. This has several advantages for sellers, including:
- Guaranteed upfront payments: With iwocaPay, you get paid immediately while your customers spread the cost.
- Risk-free financing: iwocaPay assumes the credit risk, so you’re never left chasing unpaid invoices.
- Cash flow stability: Unlike trade credit, BNPL doesn’t tie up your working capital while you wait to get paid.
To find out more about iwocaPay’s digital trade credit, why not check out our seller options?
