Let’s get straight to it. Trade credit has many benefits for both customers and sellers who issue it, but it also has many risks associated with it. Particularly for the business issuing the trade credit. While businesses may feel tempted to adopt a trade credit program to help lure in new customers and land bigger orders, sellers (and their customers) should take steps to help lower the risks associated with this business financing option.
The Trade Credit Basics: What it Is and Who Uses It
Trade credit refers to a form of business financing that allows customers to obtain inventory and pay for their purchase at a later date. Trade credit is sometimes referred to as vendor credit or “net terms” and is a practice seen amongst B2B companies. When offering trade credit to customers, they will agree to a payback date that generally lasts between 30 and 120 days.
Trade credit can be a major draw to some customers and can help businesses sell larger orders. For customers, especially small business owners, trade credit can help them bridge cash gaps and grow their business. However, there are some serious risks associated with offering trade credit that businesses and customers should aim to avoid.
When Payment is Too Late
The largest risk that a seller faces by offering trade credit is that they may not ever receive payment from their customers. Followed by the inconvenient, and potentially financially devastating, fallout of late payments. While offering trade credit will always pose some risk, having a thorough vetting process for customers can help improve the odds of working with a responsible borrower. Sellers can choose to hire a firm or a contractor that specializes in vetting a customer’s creditworthiness. Or they can tackle the process in-house. They may want to acquire references, run credit checks, or process credit applications during this process. After the application process is complete and approved, the seller will need to negotiate and issue a clear credit policy for the customer to follow.
The main risk that the customer faces when applying for trade credit is not being able to pay back the financing on time. Late payments can result in late fees. Defaulted payments can lead to a painful and taxing debt collections process. To lessen these risks, businesses should only take out trade credit if they are fairly certain they will be able to make their payments on time.
When Payment is Too Early
While it may seem like receiving a payment late, or not receiving it at all, should be the lender’s main concern, receiving a payment too early can also be damaging. Many trade credit programs offer early payment discounts which can lead to thinner margins for the seller. On the flip side, customers looking to take advantage of the benefits gained from responsibly using trade credits, should strive to take advantage of early payment discounts.
Often, early payment discounts are an incentive offered by the seller to attract customers, but doing so means losing some profit. Even if the early payment discount is small, these discounts can add up if multiple customers take advantage of them. Not to mention, discounts can cause logistical confusion for your accounting process. They can complicate financial projections as well, as you can’t be certain of what your final profit will be. If the seller offers each customer an individualized early payment incentive, that can add further confusion internally. Sellers should consider avoiding offering early payment discounts if possible.
When a Company’s Growth May Stall
Trade credit can give both parties a nice boost, but it can just as easily stall the seller’s business growth. Giving customers inventory before accepting payment can cause cash flow risks. The best case scenario is a customer pays back their debt right at the end of their loan term, but during that time the seller’s company is carrying debt to cover the cost of supplies, employees, and the vendors they must pay. If a customer doesn’t pay on time, the seller may find they struggle to pay their own bills. In which case, having a backup source of funding such as a credit card or a business line of credit may provide some peace of mind and emergency funds.
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