Trade credit has long been an integral part of the B2B landscape, tracing its roots back to the earliest days of commerce. Its significance lies in its ability to facilitate transactions, support business growth, foster healthy commercial relationships, and ensure the smooth flow of goods. Even today, trade credit remains a crucial enabler for businesses across every industry. This article will explain trade credit, how it works and outline the main ways your business can start offering it to customers.
What is trade credit?
In simple terms, trade credit is a form of short-term financing. It refers to an agreement between two businesses that allows one business (the buyer) to purchase goods from another (the merchant) without paying upfront and instead pay at a later agreed upon date. Merchants typically extend trade credit to buyers who they believe are creditworthy and have a good history of paying their bills on time with the period for repayment usually 30, 60, or 90 days. Some of the key benefits of trade credit include:
- Increased sales: Offering trade credit can help businesses increase their sales by making it easier for customers to purchase goods and services.
- Enhanced customer relationships: Offering trade credit can help businesses build stronger relationships with their customers by demonstrating that they are willing to extend credit and trust.
- Higher retention and loyalty: Customers offered trade credit may be more likely to do business with a company again, as they know they can defer payment.
How does trade credit work?
Here is a step-by-step process of how trade credit typically works:
- The buyer and merchant agree on the terms of trade credit. This includes the length of the credit period, which is the amount of time the buyer has to pay for the goods, and the interest rate, if any.
- To mitigate potential risks, the merchant evaluates the creditworthiness of potential buyers. Factors like the buyer’s financial stability, credit history, and business reputation are taken into consideration during this assessment.
- Once a buyer is approved for trade credit, they receive the goods from the merchant. This can be done in person, by mail, or electronically.
- The merchant sends the buyer an invoice for the goods. The invoice will list the items purchased, the quantity, the price, and the total amount due.
- Alongside the invoice, the merchant provides the buyer with a statement of account, highlighting the outstanding amount and the due date. The statement may also include any applicable interest charges.
- The buyer pays the merchant on or before the due date. The buyer can pay by check, wire transfer, credit card or any other agreed upon payment method.
Here are some additional details about the process:
- The terms of trade credit: The terms of trade credit are agreed upon before the buyer receives the goods. This ensures that both parties are on the same page about how the transaction will be processed. The terms of trade credit can vary from one merchant to another, so it is important for buyers to read the terms carefully before agreeing to them.
- The receipt of goods: Once the buyer receives the goods, they should inspect them to make sure that they are in good condition. If there are any problems with the goods, the buyer should contact the merchant immediately.
- The invoice: The invoice is a document that lists the items purchased, the quantity, the price, and the total amount due. The invoice should be signed by the buyer and the merchant.
- The statement of account: The statement of account is a document that summarises the buyer's account with the merchant. It lists the amount due, the due date, and any interest charges that are due. The statement of account should be reviewed by the buyer to make sure that it is accurate.
- The payment: The buyer can pay the merchant on or before the due date via any of the agreed upon payment methods. Some merchants may offer early payment discounts to incentivise buyers to settle their invoices before the due date. This can be advantageous for buyers seeking to reduce their overall costs.
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How can my B2B business offer trade credit?
A business can offer trade credit in two main ways: providing it in-house or outsourcing it to a third-party provider.
Providing trade credit in-house
When a business opts for in-house trade credit, it grants credit terms to its customers directly without relying on external financing institutions or third-party credit providers. In such a setup, the company plays a dual role as the seller of goods and the creditor, allowing customers the flexibility to make purchases on credit.
Consequently, the company oversees the entire credit process, encompassing tasks such as establishing credit limits, evaluating and sanctioning credit applications, handling payment collections, and other related functions. Below are some key factors to consider when deciding whether or not to provide trade credit in-house.
- Cash flow impact: Extending credit in-house can tie up a significant portion of a business's cash flow, potentially affecting its ability to cover immediate expenses or invest in growth opportunities.
- Credit risk: There is a risk of customers defaulting on payments, leading to potential losses for the business. It requires thorough creditworthiness assessment and monitoring of customer payment behaviour.
- Administrative costs: Managing trade credit programs involves tasks such as credit checks, invoicing, and collections, which can significantly add to operational expenses.
- Impact on relationships: Strained relationships with customers may arise if credit terms aren't met or if a business has to enforce collections strictly.
- Competence and compliance: Effective credit management requires expertise and adherence to legal and regulatory frameworks, which can be challenging for businesses without prior experience.
Outsourcing trade credit to a third-party provider
When a business outsources trade credit to a third-party provider, it is delegating the management of its trade credit arrangements and related functions to an external entity. Instead of handling all aspects of trade credit in-house, the business transfers this responsibility to a specialised firm that manages all the trade credit processes. Below are some key factors to consider when deciding whether or not to use a third-party provider.
- Expertise and infrastructure: Third-party providers specialise in trade credit management and have the necessary expertise, infrastructure, and technology to handle credit evaluations, credit decisions, and collections efficiently. They bring industry-specific knowledge and tools that can streamline the credit process and enhance risk management.
- Risk mitigation: Outsourcing trade credit helps mitigate the risk of bad debt and non-payment. The third-party provider assumes responsibility for credit evaluations, collections, and potential bad debts. They also have access to better tools for assessing customer creditworthiness, reducing the chances of extending credit to high-risk customers.
- Reduced administrative burden: Partnering with a third-party provider enables companies to offload the administrative tasks associated with credit management, including credit checks, invoicing, and collections.
- Focus on core competencies: By delegating trade credit management to an external provider, businesses can concentrate on their core competencies and primary functions, improving overall productivity and performance.
- Cost savings: Outsourcing often leads to cost savings as the business avoids investing in credit management infrastructure, training, and technology.
Wrapping it up
This article dived into a comprehensive exploration of trade credit, describing its fundamentals, and operating principles. By providing insights into the workings of trade credit, we aim to provide readers with a thorough understanding of its implications and potential impacts. Learn more about B2B payments and the buyer purchasing process here.