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Chad Morris
By: chadmorris
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What is Trade Credit? Short-Term Financing for BusinessesAccountants

If you’re a business owner, you most likely use a business credit card for the short-term financing needs of your small business. Well, most owners do. They’re the popular option because they can help finance your purchasing needs and are quick and convenient. 

But there are superior financing alternatives.

Trade credit is, often, a better option. 

Why?  For several reasons.

Trade credit costs less. But most people choose credit cards because they’re better known. With our help, you’ll be able to use trade credit, which is a better choice.

In this article, we’ll help you understand what trade credit it, how it works, and how much it can cost.

What Is Trade Credit?

Trade credit is a kind of line of credit. It’s an arrangement between 2 businesses that allow the customer to take delivery of goods without making payment immediately. With a trade credit agreement, the buyer can pay at a later time. 

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Trade credit provides small businesses with several benefits. 

  • It can help a business that’s struggling with an immediate cash flow problem obtain necessary goods and services. 
  • Trade credit can also help finance a short-term project that wouldn’t be feasible if the business had to pay upfront. 

Trade credit does have some disadvantages, too. 

  • It creates a liability on the balance sheet. Accountants call it accounts payable. 
  • It can also create a large amount of short-term debt if a business uses it frequently. 
  • Finally, trade credit can make accounting complicated. 

If trade credit does become too complex, you could instead take out a small business loan.

How Does Trade Credit Work? 

Each transaction that takes place under a trade credit is recorded on an invoice. The buyer must sign the invoice so that there is proof of receipt. Both the buyer and seller should record the transaction in their accounting records. An IOU or promissory note could also be sent with an order. 

If a seller wants a firm commitment before shipping goods, it may require a commercial draft. This will be sent to the buyer’s bank with the invoice. The bank will have the buyer sign the draft before turning over the invoice, at which time the selling firm will ship the goods.

In most cases, the buyer has anywhere from a week to 6 months to pay the invoice. Some suppliers may offer terms longer than six months. 

Typically, a trade credit doesn’t charge interest. However, a business can qualify for a discount if it pays the invoice in a short amount of time. If it doesn’t, it loses the discount.  

If the concept is still not entirely clear, do not worry. This small example will make things easier:

Trade Credit Example

A home builder may purchase lumber from a supplier on terms of 2/7, net 30. This means that the home builder will receive a 2% discount if it pays the invoice in 7 days or less. Whatever the buyer decides to do, it must pay the total invoice within 30 days. If it pays after seven days, it doesn’t get the discount. 

Let’s see the terms again: 2/7, net 30.

  • So the first number in the terms is the amount of discount available. 
  • The second number shows when the invoice must be paid to get the discount. 
  • And the final number shows the deadline to pay the invoice. 

If the supplier doesn’t offer a discount, the terms will just say “net 2 months” if the invoice must be paid within two months. 

The Cost of Trade Credit

As we can see from the above example, if a business doesn’t pay an invoice quickly enough, it loses a small percent of the invoice. A regular pattern of this can add up over time, costing a business a lot of money at the end of the year. 

Let’s say a restaurant uses a trade credit to purchase ingredients. The invoice is $5,000, and the terms are 3/10, net 2 months. It has 2 months to pay the invoice. If it pays in less than 10 days, it receives a 3% discount. 

On a $5,000 invoice, the 3% discount is $150. If it chooses to pay at 2 months, it loses the $150. That’s $75 per month on just a single invoice. 

Close-up Of A Businessperson's Hand Calculating Invoice At Workplace. concept: trade credit

On the flip side, the longer the payment terms, the lower the inflation-adjusted cost of the invoice. When inflation rises while the invoice remains fixed, the buyer saves money by delaying payment. This savings is usually much smaller than the discount offered for early payment, though. 

Trade Credit as a Business:

As we have seen, trade credit can be a significant help for a small business. But according to Entrepreneur, most suppliers won’t offer it to new companies. An alternative could be a small business loan, although most lenders require at least two years of business history. 

Camino Financial requires just 9 months of business history as a requirement for small business loans. 

Small businesses that do have an established history can ask their suppliers to grant trade credits. Most suppliers do offer this service. 

When asking for trade credit, bring your business plan and ask to speak to the owner or whoever is in charge of credit and financing. 

Getting a trade credit isn’t guaranteed. A seller wants to be sure a buyer will pay. 

Some matters a seller usually wants to verify before granting a trade credit include:

  • Credit reports. These consist of both business and personal reports. Remember that good credit utilization will improve your credit scores.  
  • Financial documents. Suppliers may want to see a business’s balance sheet, income statement, and cash flow statement
  • Payment history. If you have a good payment history with the vendor, it is more likely to extend a line of credit. 

Trade Credit as a Supplier:

If your business supplies other businesses, you can offer trade credit as a method of increasing sales. 

If you do decide to set up trade credits, remember that the business-to-business device is primarily an advantage to the buyer. A business could choose to pay early, in which case you would lose some revenue. Or it could not pay at all, leading to a loss. 

When you offer trade credit to a particular client, you’ll want to do an evaluation similar to the one we just discussed involving payment history, financial documents, and credit reports.

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What’s the Best Solution for You?

Many small businesses rely on several financing options, including credit cards, trade credits, and small business loans. A business credit card or a small business loan could be used with a vendor that doesn’t offer trade credit.

A loan from Camino Financial could also help fund an expansion project or pay for an advertising campaign. 

Whatever your financial needs, we promise “No Business Left Behind.”

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