Today, trade credit is an essential tool for companies that want to conquer new markets and build a long-term commercial relationship. Indispensable in certain sectors such as distribution or construction, trade credit does involve various risks, but there are ways to control them effectively.

What is Trade Credit?

Trade credit is an agreement between two 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 similar to a 0%-loan – referred to as a “commercial loan” – that you grant your customer when invoicing a product.

When making this agreement, it’s important to define invoice payment terms to provide details about the expected payment and specify how much time your customer has to pay.

Understanding Trade Credit Payment Terms

Trade credit payment terms are the agreed-upon guidelines for when the customer is expected to make the deferred payment. These terms should include the invoice date, the payment due date based on the deferment you extended, an explanation of penalties for late payments, and early-payment discounts if you offer them.

The payment 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 an accounts receivable discount to your customer to encourage in case of early payment.

Net Terms

Net terms indicate how long the customer has to repay you in full after you issue an invoice. For example:

  • Net 30: Customer owes you payment within 30 days of the invoice date. 
  • Net 45: Their payment is due within 45 days. 
  • Net 60: Their payment is due within 60 days.

You can offer discounts, based on these net terms, to encourage customers to pay earlier than their net term due date. For example, you could grant a customer a 5% discount for paying within 10 days of receipt of invoice. On the invoice, that discount would look like: 5/10 net 30.

You can also incentivize customers to pay on time by explaining your interest charges for invoices not paid to your net terms. You can also stipulate that payments not received according to net terms will also include debt collection costs. In many countries , such as those 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

There are several benefits to extending trade credit to your customers. It will likely increase your sales volume because it delivers you an advantage with potential clients over competitors who cannot offer these arrangements. Offering trade credit can also build strong customer relationships over time and encourage customers to stick with your business.

Of course, there are also some potential drawbacks to offering trade credit. Extending trade credit puts you at a greater risk for bad debts compared to requiring immediate payments. Your cash flow can be compromised based on your net payment terms and late payments can reduce your working capital. Your accounts receivable records will also be more complicated, requiring extra diligence from your accounting team.

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.

For more information, you can read our article on how trade credit secures your 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 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 right for all industries and companies?

Trade credit is a benefit to customers that have high inventory costs and challenges, such as the distribution and construction industries . Offering these customers trade credit means you finance their inventory with your 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. For detailed tips and advice on cash flow, you can download our ebook how to protect your cash flow.

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.

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