Financing Your Business Using Trade Credit

September 2005

Trade credit is a generic term for a businesses purchase of goods or services from a vendor who finances the purchase by delaying the date at which the price is due, or allowing installment payments. Vendors and suppliers are often willing to sell on credit and this source of working capital financing is very common for both cash strapped startups and growing businesses.

The major advantages of trade credit are that it is often readily available and allows you to spread your payments over several months or years; and minimal, or no, down payment or interest charges are assessed.

Trade credit can take the form of a delayed payment for purchases, sales on consignment, equipment loans, or a variety of different options to assist you in financing inventory and other purchases. Buying on consignment is also a form of trade credit used in certain industries. A purchase on consignment means that you pay for goods only if, and when, they are sold. The supplier keeps title to the goods and when they are sold, you retain a portion of the sale and return the balance to the supplier. There are no significant upfront costs and if you don't sell it, you simply have to return it to the supplier.

Trade credit allows a company to conserve cash for a period of time. In exchange for holding onto your cash, you incur a current liability called accounts payable. Some companies exploit trade credit, postponing payments for as long as the vendor tolerates. This practice is sometimes called "stretching accounts payable" or "riding the trade."

Stretching accounts payable can backfire as a strategy for improving cash flows if pushed too far. A company that chronically pays it vendors late may earn a reputation as a late-payer, which may hinder the relationship and constrict future trade credit. Many vendors also report late payers to the various credit reporting agencies and thus your payment history becomes available to any other vendor who performs a credit check before extending you terms. Therefore, late paying may in effect be a short-term strategy that can have long-term consequences on your credit rating and ability to borrow in the future and must be handles with care. As a business owner, you should evaluate the trade-off in stretching accounts payable and the inherent credit worthiness implications as well as potentially alienating your vendors and suppliers.

A byproduct of trade credit is usually a higher purchase price. Keep in mind that vendors often experience the same cash flow pressures as small businesses and many sellers offer cash discounts for immediate payment. By purchasing on credit, you forego the cash discount price and pay a higher relative price for your goods.

It's a good idea to learn the rules of thumb on when to take a trade discount. A rule of thumb is to take the discount and pay early if the interest rate you can earn on this "loan" is greater than your cost to borrow.

The use of trade credit is a relatively accessible and accepted strategy to help finance you cash flow needs however, it requires a judicious balance between cost and vendor relationships that are equally as important to your business. 


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