In an ideal world, businesses would always have the cash on hand they needed to buy raw materials, inventory, and supplies from vendors and settle their accounts immediately.
Unfortunately, cash is a luxury for many small businesses.
In fact, 40% of small businesses admit they’ve experienced cash shortages within the previous 12 months. In large part, this is due to the fact that 64% of small businesses are waiting on late payments, according to our analysis of over 20 million invoices.
Instead of denying cash-strapped buyers their orders—and sacrificing the accompanying revenue—some suppliers use a business financing option called trade credit to front inventory to small businesses, giving them some predetermined period of time to pay for the goods. Trade credit is also known as vendor credit, or “net terms.” This practice is very common among businesses that serve other businesses (B2Bs). Trade credit enables a small business to gain additional revenue from cash-starved businesses that cannot pay immediately.
Under these agreements, buyers get the inventory and supplies they need right away without having to pay until an agreed-upon future date.
What is trade credit?
Trade credit is a financing option that enables businesses to buy products and supplies from other companies that they don’t have to pay for right away. Sellers that grant their customers trade credit generally give them anywhere between 30 and 120 days to settle their accounts. The range, however, can be higher or lower depending on the industry and individual seller.
Most sellers that use trade credit offer discounts to customers that pay their full balance before it’s due (more on that later).
Be warned: If you use trade credit and you’re unable to pay your balance in full by the time it’s due, you may incur late payment penalties, depending on the terms of your agreement.
Who uses trade credit and why?
The popularity of trade credit spiked significantly in the wake of the 2007–2008 financial collapse, which caused traditional lenders to tighten their belts and lend fewer dollars to small businesses.
Today, 60% of small businesses use either formal or informal systems of trade credit to finance their operations, making this the second most popular form of small business financing (traditional financial institutions are first). Altogether, 43% of B2B transactions rely on trade credit for financing.
Small businesses in particular rely on this system of credit because funding from other sources, such as major banks, is so difficult to come by. Since most banks use lending criteria such as the personal credit score of the owner, along with other consumer metrics, many healthy businesses still find access to business credit out of reach. If you are unable to qualify for a business loan, you may rely more heavily on the grace periods determined by your vendors. If you’re a merchant, and your customers are primarily small businesses, you may find that you must offer net payment terms in order to stay competitive.
What are net terms?
When you finish dinner at a restaurant, the bill comes. You’re expected to pay it before you leave. You can either pay with cash, or you can do what almost everyone does, and put down your credit card.
Most consumers are so used to using credit cards that they hardly ever think about the fact that credit cards are actually a financing tool. When you charge dinner on your card, the restaurant gets paid right away, but you, the buyer, get to defer the payment. The charge goes on your monthly statement, and you have 30 days to pay. If you want, you can carry a statement balance, and pay it off over months or even year.
Net terms, just like consumer credit cards, give business buyers a cushion of extra time to pay their invoices.
Sellers and vendors that offer net terms provide the product or service right away but don’t expect buyers to pay until the agreed-upon time.
The most common net terms are as follows:
Net 30. Payment is due in full within 30 days.
Net 60. Payment is due in full within 60 days.
Net 90. Payment is due in full within 90 days.
Some industries will, however, offer as few as seven days to settle your account. Others might give you as many as 180 days. Do your due diligence to make sure you don’t get involved in a situation you didn’t anticipate.
Many vendors also offer discounts to customers that pay early.
If an invoice you receive has the terms “2/10 n/30,” for example, you’d get a 2% discount if you settled your account within 10 days of the issue of the invoice. Otherwise, the net amount is due within 30 days.
For example, imagine you receive a $2,500 invoice with the above payment terms. If you’re able to pay the bill within 10 days, after the 2% discount, you’ll only end up spending $2,450.
That discount might seem like something that’s nice to have, but not a must-have. If you use trade credit on a regular basis, however, you know it’s incredibly important.
Failure to take advantage of a 2% early payment discount could cost you 36%.
Many small businesses don’t have that kind of money to burn.
If, for some reason, you are unable to pay your invoice on time, most trade credit vendors will add interest expenses to your account. For example, let’s say a supplier’s terms indicate they charge 6% interest on late payments. You were unable to pay your $5,000 bill on time, but settle up in full 10 days after the due date. The supplier would then charge interest for those 10 days, which in this example means you have to pay $8.22 extra.
What industries use trade credit and net terms?
Any business involved in the manufacturing and distribution of products can use trade credit to accelerate their cash flow.
Trade credit arrangements or net payment terms exist in almost every industry where businesses transact with other businesses. Here are some examples of the more common businesses and situations that use trade credit or net terms:
Cleaning services. A cleaning services company might use trade credit to get the supplies and tools they need, paying their vendors back after their own customers pay them at the end of the month.
Creative agencies. A creative agency might offer trade credit to its customers, invoicing them at the end of the month and giving them 30 days to pay.
Accountants and bookkeepers. Small accounting firms that work with a number of businesses may decide to do the same thing, invoicing clients each month and giving them net terms.
Landscaping companies. A commercial landscaping business might use trade credit to procure fertilizers and other lawn care chemicals and supplies. The company may also offer its corporate clients net terms on their invoices.
Clothing companies. An apparel company might buy several pallets of plain white T-shirts on net terms and put their own designs on them before selling them and repaying their supplier.
Restaurants. A restaurant might get an order of ingredients from a food supplier on trade credit, settling their account after they’ve sold it all in meals.
Beverage manufacturers. A brewery might procure hops, barley, grains, and other ingredients on net terms, repaying suppliers as they finish a new batch of beer and sell cases to their distributors.
Construction companies. Construction businesses may use trade credit to get wood, nails, roofing supplies and more to help finance projects.
Manufacturers. Manufacturing companies may rely on trade credit to finance the production of a line of goods, settling their balance after they’ve shipped the products to a reseller.
Wholesalers. Wholesale companies may procure items on trade credit, paying suppliers back when customers buy them off the shelves.
Retailers. Like wholesalers, retailers may get products on net terms and repay suppliers once they’ve sold them.
Why do businesses offer net terms?
Why do companies end up offering customers trade credit in the first place?
There are several reasons:
It’s hard for SMBs to get other kinds of financing.
Many small businesses don’t have that a ton of financing options these days. In fact, a recent survey by the Small Business Administration revealed that 27% of companies were unable to find any source of funding whatsoever. Making matters worse, in many business-to-business supply chains, sellers simply can’t accept credit cards because margins are razor-thin and processing fees take too big of a bite out of them. Trade credit offers a mechanism to ensure SMBs can access the goods they need to continue their operations while maintaining suppliers’ profitability.
It’s a way to grow your business.
If a customer is unable to pay today but will be able to pay sometime in the future, suppliers can use trade credit to close those deals. More deals means more customers and a bigger business.
It drives competitive advantage.
Not every company offers net terms to their customers. Some companies expect payment when products are delivered or services are rendered. Companies that do offer trade credit financing gain an edge on their competitors that don’t. Offering trade credit often drives increased sales volume, since many business customers are quite able to pay, just not right away.
It proves a company is financially secure.
More often than not, businesses that are able to offer net terms have money in the bank. Would you rather do business with a company in good financial standing or one that might shutter its doors at any minute?
It builds relationships.
As all small business owners know, it’s not always easy to access cash. If you are a supplier or vendor working with other small businesses and you’re willing to extend credit, small business buyers are most certainly appreciative and more likely to do business with you.
While many companies offer trade credit for these reasons, not all of them do.
Why do some businesses decide against offering net terms?
Over the last 12 months, 93% of B2B companies have received a late payment at some time or another.
Even the most prudent small business owners aren’t immune from struggling for cash every now and again.
To avoid having to track down late payments, some suppliers avoid offering trade credit except in certain circumstances, opting to only accept cash on delivery for the bulk of their transactions. It’s the less risky way forward. In some instances, these suppliers will be doing well enough that they can dictate the terms they operate under. In other cases, suppliers lack strong cash flow and decide they don’t want to give a ton of materials and supplies to accounts that may not pay their bills on time.
Other suppliers may hesitate to give trade credit to new businesses that don’t have a track record of paying their debts. Once you’ve proven that you can pay your accounts when they’re due on a regular basis, however, these vendors are more likely to become flexible.
For the most part, though, most suppliers—and those that work with SMBs in particular—are likely to offer trade credit to businesses that meet their requirements.
What’s the best way to use trade credit?
Trade credit benefits small businesses by enabling them to spread out their payments strategically and avoid potential cash gaps. In the perfect scenario, companies procure goods on net terms, sell them quickly and then settle their accounts within the payment discount window. This enables them to increase sales while reducing procurement expenses and keeping more cash on hand.
Using trade credit effectively starts with placing an order precisely when it’s needed—and not a minute sooner. When you buy supplies today but don’t use them until next week, it becomes that much harder to take advantage of any early payment discount. By buying at the right time, you also maximize the time you have to pay.
When you’re buying goods and supplies on trade credit, you also need to make sure you don’t order more materials than you need.
The last thing you want is to end up with a ton of inventory on hand you haven’t paid for—only to find out you didn’t need it to begin with.
If you do decide to use trade credit to finance an order, it’s ideal to have adequate cash reserves on hand. That way, you’ll still be able to settle your debts if business slows down.
How do net terms help small businesses?
Why do small businesses use trade credit to get materials and supplies? There are lots of reasons.
When you’re low on cash, you can’t afford to procure the goods you need to grow your business. Unless, of course, you find a supplier that offers flexible terms and is willing to extend credit to businesses like yours.
Net terms enable cash-strapped small businesses to get the goods they need without having to put up collateral or fork over money they don’t have. In most cases, you’ll be able to complete a trade credit application quickly.
Compare that to banks, which require a seemingly endless amount of paperwork and documents and can take months to decide whether it makes sense to lend money to your company.
How do I get trade credit for my business?
Assuming your company has been in business for a while and is in good standing, you should have a relatively easy time finding a vendor that will sell you products and supplies on net terms.
Generally speaking, here’s the process you’ll have to go through to secure trade credit:
Shop for a vendor. Once you’ve decided that your business needs to use trade credit, it’s time to shop vendors and see which one makes the most sense to work with. Some vendors that offer net terms, for example, may require you to sign a personal guarantee while others might not. Search for a reputable vendor that offers you the most favorable terms.
Fill out an application. Trade credit applications require you to submit general business information, like owners’ names, what kind of business you are, how long you’ve been around, contact information, and more. In many instances, you’ll be asked to submit financial statements and tax information, too. You’ll also be required to provide a few references and estimate how much credit you’re likely to need.
Wait for supplier to run credit checks and talk to your references. Once you’ve turned in an application, the vendor will do their due diligence to gauge your creditworthiness. After checking your credit and talking to your references, they’ll make a decision.
If approved, begin negotiating terms with the vendor. Assuming your application is approved, it’s now time to figure out the fine print. You need to determine how high of a credit limit you’ll need and you’ll need to agree on payment terms, too. If you’re unable to get the rates you believe to be fairest, at least suggest revisiting the terms in the next few months as your business relationship develops. Build up a strong relationship over time and you should be able to get longer net terms, more credit and maybe even bigger early payment discounts.
While trade credit may be relatively easy for many companies to obtain, like all forms of small business financing, it is not without its downsides.
Can net terms hurt small businesses?
Trade credit definitely helps certain small businesses by making purchases more attainable. If, however, a small business is unable to take advantage of payment discounts—or they can’t settle their bills on time—this form of financing can be significantly costly.
What’s more, not every vendor offers trade credit. Companies interested in procuring materials or supplies on net terms necessarily limit their choices to working with a select slice of businesses. Fingers crossed you’re able to partner with the business you actually need.
For small businesses that sell to other small businesses, offering net terms can be risky and frustrating. Late payments and delayed payments, are large reasons for the cash flow gaps that many small businesses experience on a regular basis. According to our analysis of late payments, 64% of small businesses routinely wait for late payments, with almost half of net-30 invoices getting paid late.
When small businesses offer trade credit, floating their customers, and then have to wait for late payments, their survival is significantly threatened. For small businesses that serve other small businesses (SMB2Bs) this is a very common problem.
What are the pros and cons of using trade credit to acquire goods?
Pros of using trade credit
Trade credit can ease your cash flow worries. If you’re short on cash and need supplies, trade credit can help you get them. When used correctly, trade credit can help cash-short businesses solve money problems.
Many businesses can get access. As long as your business has a track record that speaks for itself, you’re likely to qualify for trade credit. The application process shouldn’t take too long.
No extra fees if you pay on time. If you’ve got a good plan and can take advantage of every early payment discount, you may be able to get the goods you need at favorable prices. Pay your bill on time and you won’t have to worry about any interest expenses, either.
Keep your customers happy. Getting goods on net terms enables you to keep your customers happy—even when you’re low on cash. The alternative is waiting until money comes in—however it does. Few small businesses have the luxury of leisure, so many resourceful ones turn to trade credit to bridge cash gaps and continue serving their customers effectively.
Build long term relationships with suppliers. Rely on trade credit regularly and, over time, you can develop great relationships with suppliers. The right matches can result in increasingly favorable terms and more and more credit. Repay the advances on time, every time, for long enough to improve your credit score.
As an added bonus, the better your relationships become with your suppliers, the more likely you’ll be aware of the latest industry news and trends.
Cons of using trade credit
It can get expensive - On the flip side, financing purchases via net terms can be prohibitively expensive—particularly when you’re unable to capitalize on early payment discounts.
Look out for late fees - If you can’t settle your account on time, you may be hit with significant late payment penalties, too.
Your relationships may be at risk - Suppliers that offer trade credit may be friendly—but if you don’t pay them on time, they may decide to stop doing business with you. Depending on how much credit they give you, a lack of payment could even jeopardize your vendor’s entire business.
Not everyone can get access - Finally, while trade credit has its upsides, it’s only available to established businesses. If yours is a new one, you’ll likely have to look to other sources of financing.
Summary: Pros of trade credit for buyers:
No lengthy application process
Can bridge cash gaps
No interest accrues if you pay on time
Access to the supplies and materials you need
Stay current with industry news and developments
Develop relationships with lenders
Summary: Cons of trade credit for buyers:
Expensive when you miss out on early payment discounts
If you don’t pay on time you can end up owing late fees
Not being able to pay could put suppliers in jeopardy
Limits the number of suppliers you can work with
New businesses are unlikely to be given net terms
What are the pros and cons of offering trade credit?
Some benefits of offering trade credit
1. Gain a competitive edge...or just stay competitive
Why do merchants and suppliers offer trade credit in the first place?
For starters, vendors generate more revenue when they enable customers to buy supplies and materials on net terms because businesses that would otherwise be unable to afford said products can use trade credit to procure them. Since not every vendor offers this flexibility, those that do will gain an edge on some of their competitors.
2. Establish good customer relationships
Offering trade credit is a great way for suppliers to establish trusting relationships with new customers. Over time, trustworthy relationships create loyal customers.
3. Increase sales volume and referrals
Those loyal customers can be responsible for as much as 70% of a business’ revenue, using trade credit is a no-brainer for many vendors aiming to increase their sales.
In addition to generating more sales, suppliers that offer trade credit may lock down more clients as their satisfied customers talk to the folks in their networks. In this light, trade credit doubles as a sales and word-of-mouth marketing tool.
Some drawbacks to offering trade credit
Extending credit to customers, is not without its risks.
1. Risk of customers never paying
Sometimes, no matter how hard you try to vet your customers before offering trade credit, you get unlucky. There’s always the chance that some customers don’t pay back what they owe.
2. You take on additional risk that could harm your own business
If enough of your customers are late with payments, you may run into cash flow problems of your own—which could force you to look to outside sources to finance your operations. If things go bad enough, you may have to loop a collection agency into the process and figure out how to absorb their fees, too.
3. Smaller margins or lost money
If your customers end up taking advantage of the early payment discounts you offer, you might avoid cash flow problems, but you’ll end up with thinner margins. You’ll also have to consider the cost of the additional accounting resources required to stay on top of which accounts owe what.
Pros of trade credit for sellers:
Increase sales from cash-strapped customers
Gain an edge on competitors that don’t offer trade credit
Helps establish trust and build customer loyalty
May gain additional customers via word-of-mouth recommendations
Cons of trade credit for sellers:
Some customers might not repay you
Potential cash flow problems when payments are late
Lose money on early payment discounts
May lose even more money if you need a collection agency
Additional accounting work to keep track of who owes what
Are you a small business buyer or seller who’s sick of waiting for the liquid revenue from outstanding net terms invoices? A line of credit from Fundbox can provide you with the cash to cover your expenses when you need the funding now. Invoice factoring or invoice financing are other alternatives for turning outstanding receivables into revenue quickly.