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What Is Trade Credit & How Does It Work?
Businesses whose primary customers are other businesses (known as business-to-business or B2B companies) typically engage in an arrangement of trade credit.
Whether formal or informal, this system allows for work to flow between companies without being stifled by cash flow issues or administrative delays.
The concept of ‘trade credit’ covers a number of different arrangements and often, even if you have been engaged with trade credit for some years, you may not have even heard of it.
So, exactly what is trade credit and how can it best work for your business?
Contents
What is Trade Credit?
Invoicing Terms
Cash on Delivery
Sale or Return
Instalment-Based Trade Credit
Line of Credit Accounts
Trade Credit and Trust
Examples of Trade Credit
Trade Credit Pros and Cons
Help with Trade Credit
What is Trade Credit?
Trade credit is when your company (the seller) supplies something to another company (the buyer) without being paid for it immediately.
As soon as time has passed between delivery and payment, trade credit has been established - it’s as simple as that.
Of course, at some point the bill needs to be paid and there are a number of different ways to organise that repayment. It’s the specifics of this arrangement between seller and buyer that form the different types of trade credit.
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Invoicing Terms - The Most Common Form of Trade Credit
You don’t have to be in business for long before you encounter the idea of invoicing.
An official bill for goods or services, an invoice comes with ‘terms’ - the length of time between the seller supplying the goods or services, and the day when payment is due.
We call this system having an ‘account’ with the seller, and it is often given some sort of official status with an account number or other identifier.
It works as follows:
- Buyer and seller agree on the work to be done and/or goods to be supplied.
- If one does not already exist, the seller generates an account with an account number for the buyer through which they can be identified and the history of business recorded.
- In some cases, the buyer will also generate a supplier account for the seller for similar levels of record keeping.
- Buyer generates a purchase order that lists the goods and/or services to be supplied and the agreed costs of these - as well as clearly identifying themselves through the use of the account number. This is identified by its PO number. The purchase order is sent to the seller for confirmation.
- Seller provides the services and/or goods.
- Seller generates an invoice that matches the details of the purchase order. The invoice details a total due, as well as the account details and PO number for easy cross-checking. The invoice is sent to the buyer to request payment.
- The buyer has an amount of time defined by the invoice terms to pay the invoice. Then they pay the bill, called ‘settling’ the invoice.
Not every company works in as rigid a way, as the system is quite flexible.
Many smaller companies see no need for purchase orders, for example, and some even forgo official account handling.
The number of days set as the invoice terms is part of the negotiation between seller and buyer and can be as long or as short as needed.
In the UK, the government supports the basic idea of 30-day terms by default.
What this means is that if you don’t clarify differently, the buyer has 30 days to settle the invoice amount and pay their bill. After this time there are various legal recourses available to you as the seller to claim that money back from them.
It can be important for smaller and younger businesses to clarify their payment requirements and intended trade credit systems early on in initial discussions if a standard 30-day invoicing term arrangement is not to be used.
Related: Invoice Finance - How To Borrow Money Against Unpaid Invoices
Looking for business finance? Read some of our recent business finance case studies below to get an idea of your options.
Cash on Delivery - A Simple Trade Credit Arrangement
The term ‘cash on delivery’ or ‘CoD’ is familiar to many people and expresses exactly its intent - that when the goods are delivered or the service completed, cash to pay for them is expected.
Many do not see cash on delivery as strictly a trade credit arrangement, as the idea that the goods and/or services will be paid for immediately, however, here ‘immediately’ is not entirely accurate and thus credit has been provided.
For goods, the seller has had to gather together the items needed, pack them up, drive or courier them to the agreed destination, and only then will the payment be made.
It is easy to see that work has been done by the seller before any payment is forthcoming, a situation that needs a degree of trust and an extension of credit to the buyer.
When considering cash on delivery for services, work is done by the seller before remuneration. Consider a cleaning service, where the cleaner performs their job in its entirety before being paid. Again, trust in the buyer to make that payment is given, and a credit arrangement has informally been made.
Of course, in modern transactions, the ‘cash’ part of CoD needn’t be actually notes and coins of currency, but is often a bank transfer or third-party money transfer. Despite the lack of use of actual cash, this is still a CoD arrangement.
Related: Everything You Need to Know About Trade Finance
Sale or Return - Consignment Trade Credit Agreements
A consignment trade credit arrangement is one where goods are provided to a buyer for selling, but not paid for until they are finally sold. Goods that fail to be sold after a given period are then returned to the seller.
Consignment trade credit is typically undertaken by suppliers of goods (equipment, clothes, foodstuffs, etc.) looking to sell through a shop that doesn’t want to take the risk of investing directly in the stock.
The seller gains the advantage of the shop’s infrastructure and customer base, while the buyer is able to expand their offerings without risk.
Related: Merchant Cash Advances - Borrow against your card machine sales
Instalment-Based Trade Credit
If the overall cost of the goods or services supplied is high, the seller may be willing to accept a staggered payment agreement with the buyer.
- This system works in a very similar way to an account with invoicing, only a payment plan exists to split the final bill into multiple payments.
Instalment-based trade credit agreements may be part of the seller's infrastructure, with systems already in place to facilitate monthly repayments, or it may be an ad-hoc arrangement discussed as a one-off splitting of the invoice total into more manageable chunks.
Instalment-based trade credit agreements are also often put in place by the seller to mitigate some of their risk - for example, splitting a project into four payments of 25%, one to be made immediately upon the agreement of the project, two at different milestones in the project lifetime, and the final payment at the end of the project.
Substantial service contracts and high-ticket goods often work on instalment-based trade credit arrangements.
Line of Credit Accounts
Some buyer-seller relationships benefit more from a line of credit system than a basic invoicing account. This can be for administrative reasons, where the buyer is often requesting more goods and/or services from the seller and the administrative back-and-forth of formal purchase orders and invoices is not cost-effective.
A monthly repayment plan or similar, ensures that the credit provided is regularly repaid, and additional payments can be made to clear the account or lower the credit balance if needed.
Lines of credit are good for regular customers or service B2B relationships that are secure and long-standing, reflecting the increasing trust between parties.
Trade Credit and Trust
Trade credit is built on trust.
In every version of trade credit, the seller is put in a position of risk, having to trust that the buyer will make good on the deal and pay their bill in whatever way has been arranged.
Mitigating that risk is very important.
Unlike larger financial institutions, such as banks, most companies don’t have large departments of people able to perform in-depth research on the buyer, nor do they want to risk potential sales by refusing trade credit and offending new buyers.
Invoices issued with a corresponding purchase order also form a legal contract that can be enforced legally if required.
Ultimately, however, often the seller just has to trust their gut and take the risk, evaluating each buyer and contract on its own merits.
Examples of Trade Credit
Understanding what trade credit really is and its different forms is easier with examples. The following are a few examples covering the different forms of trade credit, as well as some that seem like trade credit but are not.
Freelance Graphic Designer Making Brochures
Jim is a freelance graphic designer running a small business as a sole trader. He has been asked to design, print, and deliver 1000 brochures for a local independent cinema.
Jim agrees to the contract but asks that 30% of the total fee be paid in advance, to cover his early costs and mitigate a portion of the risk. This is agreed.
Jim opens a buyer account for the cinema, listing them as a new client. He immediately invoices the cinema an initial invoice for 30% of the total, asking them if they have a purchase order system in place. They do not. Jim explains for the first invoice, he will only accept 7-day terms, and cannot begin work until this invoice is paid.
The cinema pays his first invoice immediately so Jim can begin work. After some time, he has completed the brochure design and needs to take them to be printed.
Here, Jim becomes the buyer while the printing company is the seller. Jim arranges to have the brochures printed and delivered to him cash on delivery, a system offered by the printing company.
With the brochures now complete, Jim delivers them to the cinema along with his final invoice which covers the remaining 70% of the project budget. Confident in the cinema as a buyer, Jim is happy with 30-day terms on the invoice.
The invoice is paid 30 days later as agreed and the job is considered complete. Jim retains the cinema on his books as a client with an account, happy to work with them again.
Small Building Firm
BCT Carpentry and Brickworks is a limited company of seven people that undertakes small but regular residential building work across London. Cashflow is often tight as they have to buy substantial amounts of materials to do the work before being paid by the client. A large job is on offer for a substantial building extension, but BCT does not have the cash flow needed to purchase all the supplies before work.
The company is known to a local building materials supplier whom they regularly buy from, but have always paid upfront. BCT approaches the supplier for a trade account and, thanks to their regular custom, is offered a line of credit account that will cover the materials needed for this job plus provide a cashflow solution for future use.
Car Insurance
Simon is looking to get car insurance. He approaches an insurance company that offers him the option of paying monthly rather than footing the entire bill upfront. Simon chooses the monthly option. He believes this to be an instalment-based trade credit situation, however, it is not.
The insurance company pass Simon’s details onto a financial loan provider, who takes out a full loan credit agreement directly with Simon to pay his insurance. The insurer receives their fee immediately and does not directly offer any credit at all, while Simon is now in receipt of a loan with the provider.
This is not trade credit.
Electronics Manufacturer
DibbleComp is a maker of specialist PC equipment. They work with many suppliers of components and services, enjoying a number of accounts with invoice terms as a buyer. DibbleComp has a well-structured purchase order system in place to facilitate and administrate these B2B transactions.
DibbleComp is looking to sell its new product, however, the technology involved means the price of the product is significant and they are finding that its usual buyers are reluctant to invest without knowing there are any definitive sales to be made.
All ten retailers take on the offer and within three weeks, a total of 131 units have been sold to the public with excellent reviews.
DibbleComp is able to approach its other retailers with confident sales figures, returning to its previous model of direct sales to the retailers without the need to lean on the consignment trade credit option. Additionally, all ten of the test retailers order more units via direct sale once their SoR stock has been sold.
Trade Credit Pros and Cons
Advantages of trade credit for the seller
- Greatly increasing customer base - Limiting your customers to only those who can (and will) pay immediately is going to significantly stifle growth.
- Return business - Customers with trade credit agreements are far more likely to return.
- Better word-of-mouth - Customers who have been provided with trade credit are far more likely to recommend your business to others.
- Improved forecasting - Regular custom and a clear map of future income make business account forecasting far simpler.
- Improved relationships and reputation - Client relationships are built on trust, and trade credit shows trust. Over time, providing trade credit helps improve your business reputation.
Advantages of trade credit for the buyer
- Access to goods and services without cash flow - If you need to pay for everything right away, cash flow can become strained quickly, stifling growth and placing considerable stress on the smooth running of the business.
- Ability to take on larger jobs - The additional skills, materials, and other resources needed to undertake larger projects are needed now, while the payment for the completed project may not happen for months to come. Trade credit provides businesses the ability to take on projects that would otherwise be closed to them.
Disadvantages of trade credit for the seller
- Strain on cash flow - One way of looking at trade credit is to relax your customer’s cash flow by straining your own. It’s fine if you are in a position where your cash flow is strong, but offering trade credit when your own cash flow is problematic can add additional problems.
- Administrative costs - The process of discussing trade credit arrangements, generating invoices, and potentially chasing payments, is not automatic. These tasks do add an administrative overhead to the business.
- Potential to damage relationships - Stress and worry over trade credit being repaid, or problems with tight cash flow, can lead to resentment or other problems with your customers - especially if invoices are paid late and you have to open unwanted conversations about the debt.
- Risk of non-payment - The largest disadvantage is the worry that the buyer ultimately doesn’t pay, leading to problems where money has to be recovered or unpaid debts are simply written off. Should a debtor fall into liquidation, it may be that the trade credit is a liability that is never covered.
Disadvantages of trade credit for the buyer
- Credit always needs to be repaid - Though trade credit does relax your cash flow, it does not absolve you of the responsibility of ultimate payment. Your debts must always be covered.
- Overstretching - As with all types of credit, there is a risk of overstretching your budget with trade credit, adding obligations to pay on an already strained capital and cash flow.
- Risk of damaging relationships - Missing payments or otherwise failing to fulfil your obligations can damage the relationship you have with the supplier and prevent you from using them again in the future.
- Risk of damaging reputation - Beyond simply upsetting your creditor, late payment or non-payment of debts can have a significant impact on your reputation and business credit history.
Help with Trade Credit
There are a number of financial products that are here to help with trade credit problems should they arise. Invoice financing, for example, offers an excellent solution for the problem of cashflow while waiting for invoices to be paid, while trade credit insurance covers businesses for situations when customers delay or default on their debts, and business credit report services can provide insight into the companies you are considering for trade credit.
Clifton Private Finance are here to aid businesses with their financial standing and can advise on any aspect of trade credit, as well as arrange several finance packages to make the process smoother. Contact us today.
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