In today's entrepreneurial landscape, and especially in the B2B world, trade credit play a fundamental role. Buying on credit represents the best solution for many companies, especially smaller ones, as it allows for maximizing liquidity and optimizing business operations.
For those who sell, trade credits can open new horizons of opportunity but also present a series of potential risks. In this article, we will explore in-depth the benefits and risks of selling on credit, and how proper management can transform this tool into a powerful ally for your business.
What is Trade Credit?
A trade credit arises when a company (the seller) allows a payment delay to a customer (the buyer), postponing the payment to a date after the delivery of goods or provision of services. The number of days for which credit is granted is usually agreed upon by both parties and is generally set at 30, 60, 90, or 120 days. In some cases, companies can negotiate longer payment terms, thereby gaining an additional advantage.
Granting payment terms involves both costs and risks for companies. It is a cost because it implies giving up the liquidity of a certain sum for a defined period (equivalent to the duration of the credit plus any payment delay). It is also a risk, given the possibility of not fully or partially recovering the credit, or suffering payment delays. Therefore, it's vital not just to carefully consider the amount of credit to grant, but also to thoroughly analyze the risk profile of your buyers.
Let's take a concrete example to better understand the operation of trade credits. Suppose a transaction between company A and company B. A supplies products to B, allowing a payment term of 60 days post-delivery. This payment delay constitutes a trade credit. While this tool represents a competitive lever for A to incentivize B's loyalty, it exposes A to the risk of insolvency, negatively affecting its working capital.
The Benefits of Trade Credit
One of the main advantages offered by trade credit is the access to a broader market. When a company offers the possibility to buy on credit, it attracts a wider audience of customers, including those who might not have immediate funds to make a purchase. This strategy can lead to an increase in sales volume, allowing the company to grow more quickly.
Furthermore, trade credit can be a useful tool to build and strengthen relationships with customers. Offering flexible payment terms shows trust and respect for the customer's needs, encourages loyalty, and promotes future transactions.
The risks of Trade Credits
On the other hand, selling on credit also has some disadvantages that deserve consideration. Firstly, when a company sells on credit, it gives up a portion of its cash flow until the customer makes the payment. This can create liquidity issues and might prevent the company from investing or conducting its daily operations.
In addition, selling on credit exposes a company to the risk of insolvency. There's always the possibility that a customer might delay or completely miss the payment due to various reasons, such as financial difficulties or company failure. This credit risk, if not managed correctly, can lead to significant financial losses.
Management of Trade Credit
To minimize the risks associated with selling on credit, it is crucial to implement active and effective management of trade credit. This can include various aspects, such as checking the customer's credit history before extending credit, offering incentives for early payment, and establishing an efficient recovery process.
A good Credit Management process, for example, establishes clear criteria for credit approval. These criteria can include analyzing the customer's financial information, such as balance sheets, cash flow forecasts, and the debt/equity ratio. Furthermore, companies can use commercial information agencies to assess the customer's solvency.
It is also important to regularly monitor trade credits to identify any payment delays promptly. This allows the company to intervene before the situation worsens, for instance by initiating collection procedures or modifying the credit terms for the customer in question.
Moreover, to mitigate the risk of insolvency, many companies choose to insure their trade credits. This type of insurance, known as trade credit insurance, covers the company in the event of non-payment by the customer, protecting it from potential financial losses.