Trade credit financing refers to the practice of vendors allowing your business to place and receive orders without making an immediate payment. The vendor gives you a fixed period of time to make the payment, typically 30, 60 or 90 days. This method of financing creates advantages for you and the vendor, but also generates some disadvantages.
Advantage – Minimal Cash Outlay
Trade credit financing provides a way for you to keep the shelves of your business stocked or build a product without a huge outlay of cash up front.
If you make regular sales, the incoming cash flow from those sales should serve to pay your vendors on time and net you a profit. You can use the money trade credit lets you keep on the books as working capital for payroll, infrastructure improvement or maintaining a cash cushion. As long as you pay your invoices on time, trade credit operates like a loan without any interest attached.
Advantage – Discount for Fast Payments
Under many trade credit agreements, payments you make within a certain number of days get a discount. For example, a common approach to trade credit provides a 1 or 2 percent discount, if you make payment within 10 days of an invoice due after 30 days.
If your business maintains a healthy cash flow, early payment makes sense, because those savings represent pure profit with zero overhead costs. Even small savings every month can add up to substantial boost to your end-of-year bottom line.
Disadvantage – Fees and Penalties
Just as your suppliers offer discounts for early payments, they impose fees and penalties if you pay them late. The penalties, like discounts, typically range from 1 to 2 percent. If you pay every invoice late, the total costs over the course of the year represent a serious hit to your bottom line.
For example, if you pay a 2 percent penalty every month on a $2,000 invoice, that adds up to $480 a year. If you pay five or 10 vendors late every month, that cost easily escalates into thousands of dollars lost every year.
Disadvantage – Loss of Trade Credit Privileges
Vendors operate under no obligation to extend trade credit to your business. Many vendors even refuse to consider offering it until you establish a history of reliable payment with them. If you make a habit of paying late or fail to make payments on past-due invoices, your vendors may revert to demanding immediate payment on all orders.
In extreme cases, vendors sever their relationships with businesses that fail to pay or make irregular payments. You may also find that other vendors refuse to provide trade credit if your relationship with a vendor sours over payment issues.