What is Trade Credit? Loans 101
- March 27, 2021
- 6 min read
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Are you familiar with the term trade credit? If you are a business that needs to purchase goods or services, trade credit can be a very helpful tool when balancing your budget and establishing credit. It is one of the easiest and most important sources of short-term financing available. If you have not already encountered trade credit, it’s very likely you will see it during the life of your business.
Trade credit benefits both parties involved and helps to build relationships, so you may find yourself on either end of the deal at some point. Regardless if you are the buyer or the seller, it’s an increasingly popular way of doing business because it keeps inventory moving and offers more flexibility.
The seller might push for a buyer to use trade credit so they can create a bigger sale.
The buyer may not need to rely on trade credit but will choose to take advantage of the purchasing power to free up funds for another project. There are multiple ways that trade credit can be beneficial to your business.
Trade credit is a less formal financing solution to help keep the flow of goods or services moving between a buyer and a seller, typically two businesses. It is a form of short-term loan for buyers that allows them to make purchases now and pay at a later date without incurring any interest. This allows the additional buyer time to sell the goods and bring in extra cash to pay off the debt.
Each vendor has its own way of doing business, but this type of agreement is usually done between two businesses that have established some history together. Being that it is less formal, you don’t have the typical modes of assessing credibility, so it may take some time before you can feel comfortable operating in this way with another business. Once the relationship has proven to be trustworthy, the seller may decide to extend the terms.
In the beginning, you should start off with a modest amount of trade and always be sure to pay or receive funds on time. Most sellers will charge a penalty fee if the buyer does not hold up their end of the bargain on time. Some vendors offer discounts as an incentive to pay the invoice ahead of schedule, and if you have the funds to do so, you will be able to use more trade credit in the future.
Net 30 is typically the most common payment agreement, which means you have 30 days from the time of delivery to make good on the invoice. Next would be Net 60 (due in 60 days) and Net 90 (90 days), but they can go all the way up to 180 days, depending on the industry. It’s usually advised not to extend credit terms out too far unless you have a long credible history with the other party.
It’s pretty clear how trade credit is beneficial to buyers, being that they are able to receive goods without paying for the first, but it’s also good for sellers as well. It is common to offer trade credit as a means of increasing sales. A buyer may be more inclined to add more goods to their order, knowing they will have extra time to pay it back. This allows the buyer to add to their inventory without paying additional fees, which will add to their bottom line as well.
Offering trade credit to your customers will give you a competitive edge over other sellers. Not all businesses are in a place where they can sustain the time-lapse between selling goods and receiving funds. If you are able to keep your business operating as usual while giving customers some wiggle room on their accounts payable, it’s going to help your customer increase their sales, which will lead to more sales for you in the future.
Most importantly, building a trade credit relationship with other businesses helps foster loyalty in the industry. It means that both of you respect each other and deem the situation to be trustworthy, which can go a long way when competitors try to steal your business. There will always be new business opportunities, but if customers know they can get extended terms with you, they’re more likely to purchase from you again in the future. It’s the “scratch my back, and I’ll scratch yours” kind of attitude that strong businesses are built on.
The most obvious negative effect of using trade credit is that it creates a hole in the seller’s cash flow. When you don’t receive funds from your sales immediately, it can interfere with paying bills on time. At the same time, if the buyer doesn’t budget their profits appropriately, they may have a hard time paying their bill when the time comes due.
Since businesses offering trade credit don’t go through the same set of practices that normal lenders do, it can be a risky agreement for them to take on. Without doing a formal credit check, you must rely on references and your first-hand experience, which isn’t always the most reliable. Inevitably, some buyers will pay their bill late, and that will trickle over into the sellers cash flow. On the buyer’s end, it usually ends up costing them more in penalty fees and hurts their reputation for utilizing trade credit in the future.
Lastly, extending trade credit can be time-consuming for administrative staff. Some companies may choose to do a little more due diligence on their buyers before offering credit terms, which takes time and energy. In addition, depending on the number of accounts using trade credit, managing accounts receivable can take away from other important tasks. If one overdue account goes unnoticed, it directly affects your monthly profit. The buyer also needs to take time to keep track of what vendors they owe to avoid accruing penalty fees. That lingering debt can become a burden.
If you are not in a situation where trade credit is offered, don’t fret – there are a number of other financing solutions available. We’ve listed a few for you below:
You can obtain a short-term loan from a bank, credit union, or online lender, and they are good for temporary personal or business needs that can be paid back quickly. You will go through a credit approval process and receive individual terms such as an interest rate and APR.
A long-term loan is similar to a short-term loan, except they are meant for larger purchases and paid back over a longer period of time. Interest rates are usually lower on these types of loans since you pay on them longer.
A business line of credit will provide your business with a set amount of funds to use as you see fit on short-term operating expenses. As you pay down the balance, a revolving business line of credit will allow you to borrow more money without applying for more credit.
Having a trade credit agreement with other businesses can be a valuable financing tool for both parties involved in the transaction. The seller will have a competitive advantage over other vendors, and the buyer will have extra time to create more revenue and keep the sales flowing. Once the relationship is established and proven to work, it can help improve the bottom line for both companies.
The approval process is not set in stone, so it should be done between two businesses that have established a good rapport with each other. It is easier for the buyer than applying for traditional credit, but it is on the seller to do their own due diligence and feel confident that the buyer is trustworthy. It is usually best to begin with a small credit line and increase terms as you go. If everyone is doing their part, it’s an excellent way to build credit and manage company finances.
If the agreed upon terms are working for both companies, it’s a great way to build loyalty within the industry. Stating that you believe in someone else’s business practices, and you are willing to take on the risk associated with their creditworthiness, can go a long way in business. It’s also saying that you will do what you can to support the future of their business, so they are likely to remain loyal to your company for future sales. Remember that your reputation is on the line, so you should always be sure to deliver your end of the bargain. You don’t want to burn any bridges and make it harder to acquire trade credit terms in the future.
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