What is trade credit?
Here is a trade credit definition: an agreement between two B2B companies, where a supplier of goods or services accepts a deferred payment from its client.
This agreement does not cost your customer anything: they do not pay any fees or interest.
A trade credit agreement is a sort of 0%-loan – referred to as a “commercial loan” – that you grant your customer when invoicing a product.
When making this agreement, you need to define invoice payment terms to provide details about the expected payment and specify how much time your customer has to pay.
The payment terms of a trade credit
The deferments granted generally range from one week to three months, and are counted in number of days (7, 10, 30, 60...).
At times, you may set up a discount to your customer in case of early payment.
Example. A client is granted a trade credit with terms of “5/10 net 30”: if payment is made within 10 days, the client is offered a 5% discount. If not, the full amount is due within 30 days.
Conversely, penalties for failure to meet payment deadlines can be set against a bad payer, usually through interests (around 8-10%) on the outstanding debt owed from the day after the due date of your contract. In certain cases, you can also ask to get compensation for debt collection costs.
In many countries like in the European Union, such penalties are statutory and benefit from a regulatory framework. You should check the laws that apply to your contract before setting your payment terms.
The advantages and disadvantages of trade credit
The advantages and disadvantages of trade credit for the client
Trade credit is a potential important source of financing for your client. Such loans are registered as “accounts payable” on your client's balance sheet: they make up part of the company's working capital and have a direct – and positive – impact on its cash flow.
Trade credit can also help companies to finance their current operations, especially during certain periods of high activity (for example a retailer as the holidays draw near). It’s also very useful for new businesses or startups which don’t have yet access to bank loans or sufficient fundraising.
On paper, trade credit looks like free money to the client. However, failure to meet payment schedules can result in major penalties according to the negotiated terms as well as damage the client's reputation and its relationship with the supplier.
You should always check your client’s credit history or run customer credit checks before contracting with a new client.
Is trade credit for all industries and companies?
The advantages mentioned above are crucial for certain industries, notably those with strong inventory costs and challenges – for example distribution or construction: trade credit helps the client finance its inventory with its working capital.
All sizes of business can benefit from it, although mid-sized companies are best positioned to benefit from the advantages of trade credit: they have greater bargaining power than SMEs, but fewer financing options than large companies.
In mass distribution, the negotiating power of major stores is strong. A company like Walmart in the USA is known to negotiate tough payment terms with its suppliers.
The advantages and disadvantages of trade credit for the supplier
On your side of things, trade credit has multiple advantages: it is an effective way for you to win new contracts, increase your business volume and build loyalty among your clients.
Still, trade credit also has its disadvantages. A commercial loan is an account receivable that weighs on your working capital and cash flow: it is cash that is not collected on the date of invoicing.
Above all, you expose yourself to late payment or non-payment. This is bad debt potentially very difficult to recover, especially if your client goes insolvent or bankrupt.
Ultimately, trade credit requires significant internal resources to be efficiently managed – especially in case of complications.
How to mitigate the risks of trade credit
To manage such risks, good cash flow management is key. Another solution is trade credit insurance. It provides you with predictive protection and compensation in the event of a bad debt. Concretely, it means that if a client doesn’t pay you on time, the insurer will reimburse a percentage of the outstanding credit. This type of coverage is very flexible and can cover all or part of your client portfolio.
Other credit risk solutions make it possible to have your receivables financed while they are being collected, or even to assign them to a third party. Each solution has its own advantages and disadvantages.
In conclusion, trade credit is a powerful tool for you to accelerate your commercial development and improve your customer relations, with limited risk if properly controlled. Solutions like trade credit insurance prove very useful and efficient for managing trade receivables and taking full advantage of the benefits of trade credit.
