B2B companies often do business on credit which involves the seller offering a time period to the buyer to make the payment. For example, if Company A orders 1 million chocolate bars from Company B, then the payment terms could be such that Company A has to pay within 30 days of receiving the order. This arrangement between the two companies is generally known as trade credit.
The credit limits offered to the buyers generally vary depending on their credit history and relationship with the seller or the service provider. Mid-sized businesses often have a more informal trade relationship, while enterprises take a more calculated and formal approach.
There are three main types of trade credit. They are:
Smaller businesses often don’t sign a formal agreement with their customers while extending trade credit. Such a system is called an open account.
When the seller and buyer have a formal agreement for extending and receiving trade credit before the sale, it is called a trade acceptance. Before the seller ships the goods or provides their services, the buyer must sign the agreement.
It is a debt instrument where the buyer promises to pay a particular amount before the due date to the seller. It is also a formal agreement between the two parties before the sale goes through.
Although the concept of trade credit is simple, it often comes with some additional terms and conditions. These details affect the business and the customer to a considerable degree. Therefore, it’s essential to know what they are.
Suppliers or service providers would naturally want to receive their payments as early as possible. However, they cannot enforce strict credit terms because that would reduce their sales. So, most companies employ the early payment discount method.
In this method, a business offers its customers a flat discount for paying within a particular time frame. Let’s say a business generally offers a credit period of 30 days. To entice customers to pay earlier than the allowed 30 days, the business would offer a 2.5% discount (an early payment discount) to customers who pay within 10 days.
An important point to note here is that most of the time, the discounted amount is the product’s real value. So, customers availing the whole credit period often pay a small premium for the goods or services.
A report from Brodmin suggests that more than 50% of businesses are expecting late payments due to the pandemic. Therefore, service providers are inclined to charge late payment fees to improve their cash flow.
Customers should take extra precautions like having an emergency cash reserve or ordering conservatively to ensure that they are able to pay their dues on time. Otherwise, they might even have to shell out 10-15% (annualized) as late fees in some cases.
Businesses should aim to pay their suppliers on time to keep their business’s credit record clean and maintain good relationships with the sellers. As a customer, if you still fail to pay before the due date, it’s crucial to contact the seller and let them know the reason. It is quite plausible that they will waive off the late penalties if they find the reason genuine.
|Trade credit is very affordable for buyers and practically free if paid on time. There is also a discount associated in most cases if you pay early.||The average late fee charged for delayed payments is 1.5% per month. So, if a customer is unable to pay on time, the credit gets very expensive.|
|Businesses that struggle to maintain a healthy cash flow find trade credits useful. It helps allocate funds to expand business operations rather than paying for goods or services in advance.||Sometimes a business might find it challenging to pay back on time because of the short-term nature of trade credit. In such cases, it's better to look for long-term financing options.|
|Using trade credit options offered by businesses and always paying on time is a great way to improve your business credit score.||If a customer is unable to pay back on time, it could even hurt their credit score or rating.|
|By offering trade credit and payment flexibility, B2B businesses are often able to see an increase in their sales volume. It also makes it easier to bag larger orders.||If a business operates on low profits and is not cash-rich, then offering trade credits to customers could be a problem. It will lead to delayed revenue and may impact business operations.|
|By extending trade credit, it becomes easier to attract smaller businesses and have an advantage over the competition. It’s because these businesses often have cash problems and find it easier to pay their suppliers once they receive the payment from their customers.||Businesses need to be proactive and have an effective collections team to collect credit dues on time. This creates an extra cost for the company and puts more pressure on the AR team. The DSO or the average collection period of businesses might rise significantly if their collection process isn’t efficient.|
|Businesses offering trade credit to customers are seen as more financially secure. It also gives them an advantage over the competition.||Undue trade credits are often the cause of bad debt. Many companies that offer trade credit indiscriminately face cash flow challenges.|
Trade credit is vital for both buyers and sellers. For sellers in the B2B space, it is essential to give credit just to stay relevant in the industry. On the other hand, trade credit is sometimes the only financing option available for buyers, especially small and mid-sized businesses.
Trade credit appears on a buyer’s balance sheet as accounts payable (AP) and a supplier’s balance sheet as accounts receivable (AR). However, it can also be thought of as debt without any interest.
Trade credit doesn’t involve any interest if the buyer pays within the agreed due date. In case they fail to do so, the supplier might charge a late payment fee.
Trade credit is provided for a short-term time period which ranges between 30-120 days.
Trade credits fall under the current liabilities category because they are expected to be cleared within one year.
Trade Insurance is a protection against bad debts which occur when the customer is either unable to pay or pays after the due date..
Trade credit allows small businesses to procure goods and services without having to pay upfront, making it a source of finance.
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