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• 18 Sep

  What Is Trade Credit And How Does It Work

  

  Deciding to offer trade credit is a big decision for any business. It can be a prerequisite to doing business but it comes with certain risks, costs and a potential impact on your cash flow.

  What Is Trade Credit?

  Trade credit is when a business offers its customers (or debtors) a period of credit to pay their invoices. This is often something that customers will seek in order to deal with a particular supplier. The granting of credit may make the difference between purchasing and not purchasing from a particular seller.

  Typically, this type of credit is unsecured (assets and guarantees are not normally pledged to support it), unlike most forms of bank credit. This creates an inherent risk should the debtor default.

  How Does Trade Credit Work?

  Trade credit works by granting the customer a period of time in which to settle their invoice. This benefits the cash flow of your customers as they now have a period of time to sell goods or provide services in order to raise the money required to pay your outstanding invoice. However, this obviously comes at a cost to your business as you have to wait to get paid.

  Typically, in the UK customers will often be offered 30 days credit in many industry sectors. This does not apply to all, in some cases, it can be a longer or shorter period of time.

  Payment Discounts

  In addition to offering a period of credit, it is sometimes the common practice to give customers a small discount on the invoice value if they pay within the set credit period.

  Credit Limits

  It is good practice to set a credit limit for each customer. The credit limit is the maximum amount of invoices that are allowed to be outstanding at any given time. This ensures that the amount of credit granted to a particular customer stays within a reasonable boundary.

  See our credit control guide for more information about setting customer credit limits.

  What Are The Risks Of Offering Customers Time To Pay?

  The key risk of offering customers time to pay is that they can run up a credit account and then fail to settle the balance. Keeping these accounts in good order is part of the credit control process of any business.

  See our article about Mitigating The Risk Of Customer Payment Defaults

  Who Bears The Cost Of Offering Credit Accounts?

  The cost of offering credit accounts to customers is ultimately borne by the supplier. Having said that, it is often a cost of doing business that cannot be avoided.

  What Is The Cost Of Offering Trade Credit?

  There are models available that will allow you to calculate the cost of offering time to pay to customers. This is an example of a trade credit calculator. You are able to enter the amount of credit days being offered and the Calculator works out the potential cost to your business. You can then compare this cost to the cost at which you can borrow.

  Making this comparison allows you to see if you would be better off granting credit or Increasing your borrowing. Having said this, as stated above it is often the cost of doing business.

  How Can Granting Credit Accounts Affect Your Cash Flow?

  Granting credit accounts will have an impact on the cash flow of the supplier. The issue is that you now have to wait for a period of time in order to be paid, this reduces your liquidity and can cause you to need to borrow more funds.

  However, there are potential receivables financing solutions that will allow you to negate the cash flow impact of offering credit accounts. They work by releasing the cash tied up in unpaid invoices prior to the customer making payment.

  GET AN INVOICE FINANCE QUOTE

  Cash Flow Solutions

  In addition to using bank overdrafts or loans, receivables financing offers a range of possible cash flow solutions. Invoice discounting facilities allow you to access the cash tied up in your invoices whilst maintaining your own credit control systems. Invoice factoring allows you to both outsource your credit control activity and receive cash against your unpaid credit invoices.

  By Glenn Blackman