how a business line of credit works – It can provide better cash flow, buying power, and supplier relationships. And when used wisely, this can be a valuable asset to any business.
In this article, you will learn what this type of credit is and how it works, in addition to its advantages and costs.
What is trade credit?
Trade credit is a type of line of credit. It is a type of credit that suppliers grant to companies. It allows businesses to purchase goods or services before they have the cash to pay for them.
This credit can provide working capital to cover inventory costs, expansion, or other business needs. It is an essential tool for managing cash.
What is the importance of trade credit?
Trade credit is essential because it allows businesses to purchase the goods and services they need to function without having to pay for them upfront.
This can be useful for businesses that are just starting out and don’t have a lot of cash flow or for companies that need to build up stock before a peak season.
Lastly, it helps businesses build a good credit history. This can help companies to get financing in the future.
Advantages and Disadvantages of Trade Credit
Trade credit provides several benefits:
- You can help a business struggling with cash flow to get needed goods and services.
- Flexible payment terms when paying for goods or services. This can be useful for managing cash and preserving working capital.
- Greater purchasing power can help companies take advantage of early payment discounts, or special price offers from suppliers. This can save money and help improve profitability in the long run.
- Improving relationships with suppliers Establishing a good relationship with suppliers can lead to more favourable conditions, better prices and delivery times.
- Protection against risks, such as fluctuations in the prices of raw materials or unexpected changes in market demand.
How does trade credit work?
Every transaction that happens under a trade credit is recorded on an invoice. Then the shipment is made. The buyer must sign the invoice for proof of receipt.
The buyer and the seller must record the transaction in their accounting records. You can also send a promissory note.
In most cases, the buyer has from one week to 6 months to pay the invoice issued under the credit. Some providers may offer terms longer than 6 months.
Typically, interest is not charged for this type of credit. However, a business may qualify for a discount if it pays the invoice quickly. If you don’t, you lose the deal.
Trade Credit Example
A home builder can purchase lumber from a supplier on 2/7 terms, net 30 days. The builder will receive a 2% discount if he pays the invoice in 7 days or less.
Regardless of the buyer’s decision, they must pay the full invoice within 30 days. If you pay after 7 days, you don’t get the discount.
Let’s look at the terms again: 2/7, net 30 days.
- The first number in the terms is the amount of discount available.
- The second number shows how long the invoice must be paid to get the discount.
- And the final number shows the due date to pay the bill.
If the provider does not offer a discount, the terms will only say “net 2 months” if the invoice payment is due within 2 months.
Types of Business Credit
There are three types of business credit: revolving, instalment, and open account.
revolving credit
It is a type of credit that allows the borrower to borrow and repay the money several times during a specific period. The most shared example of revolving credit is a business credit card.
instalment credit
It is a type of loan in which the borrower repays the debt in fixed monthly payments over a predetermined period. For example, a mortgage or a car loan.
Credit with an initial fee
It is a type of credit in which the borrower provides a down payment to guarantee the loan. The down payment reduces the quantity of money the lender has to finance, indicating that the borrower is serious about obtaining the loan.
The conditions of the loan will vary depending on the amount of the initial payment, the purpose of the loan and the borrower’s solvency.
open account credit
It is an agreement in which the seller allows the buyer to purchase goods or services and pay for them later. The most common example of open account credit is buying food at the supermarket.
Credit secured with a check.
It is a commercial credit in which the creditor has a check from the debtor as a guarantee for the loan, and it is also usually short-term. The interest rate of this credit is generally higher than that of other commercial loans because there is more risk for the lender.
The cost of trade credit
As we see in the instance above, if a company doesn’t pay an invoice fast enough, it loses a small percentage of it.
A regular pattern of this can add up over time, costing a business a great deal of money at the end of the year.
Let’s say a restaurant uses trade credit to purchase ingredients. The invoice is for $5,000, and the terms are 3/10, net 2 months.
The restaurant has 2 months to pay the bill. If you pay in less than 10 days, you receive a 3% discount.
On a $5,000 invoice, the 3% discount is $150. This equates to $75 per month on a single bill. If you choose to pay after 2 months, you lose that $150.
On the other hand, the longer the payment terms, the lower the invoice cost adjusted for inflation.
When inflation rises while the bill remains flat, the buyer saves money by delaying payment. However, these savings is usually much less than the discount for paying early.
