What Are the Advantages and Disadvantages of Trade Credit?

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.

Benefits 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 of Trade Credit for the Client

Trade credit offers additional advantages for businesses that seek to make purchases without upfront or immediate payment. While there are some disadvantages, the benefits for buyers are significant.

Facilitates Startup Businesses

Trade credit is particularly beneficial for new businesses that face challenges in securing funding or business loans. It allows these startups to quickly acquire stock and materials necessary for their operations, even without an established trading history.

Enhances Competitive Edge

Buying goods on credit provides businesses with a competitive advantage over competitors who must make upfront payments. By utilizing trade credit, businesses can be more flexible in adapting to market demands and seasonal variations.

Improves Cash Flow

Trade credit eliminates the need for immediate cash payment. Buyers can stock up on inventory in anticipation of peak demand, such as placing larger orders to take advantage of seasonal selling periods. Trade credit proves advantageous when cash flow is low after a seasonal decrease in net income, as it enables the purchase of sufficient stock for peak selling times.

Offers Affordable Financing

Trade credit can be seen as an interest-free loan, allowing businesses to retain cash within their operations. It provides access to working capital at no cost and involves less administration compared to arranging short-term loans.

Easy to Arrange

If a business has a solid credit history, meets supplier requirements, and demonstrates the ability to make regular payments, trade credit agreements are generally easy to arrange and maintain.

Strengthens  Business Reputation

Consistently making timely payments against trade credit establishes a positive track record for a business and enhances its reputation as a reliable customer. Suppliers may recognize this reliability and treat the buyer as a preferred customer.

Discounts and Bulk Purchasing

Trade credit customers who pay early may receive appealing discounts, making it an advantageous way to obtain cost savings.

Additionally, trade credit is a potentially 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.

The Advantages 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.

Winning New Contracts

Offering trade credit gives suppliers a competitive edge in attracting new buyers. By providing trade credit, you make it easier to buy from you. That’s attractive to potential customers, making you more competitive and helping to lower your customer acquisition costs. 

Increasing Your Business Volume

Suppliers can combine trade credit with bulk discounting strategies to encourage buyers to make larger purchases. When buyers experience a high demand for their stocked products and quickly sell out, they are more likely to return to the same supplier to replenish their inventory.

Building Loyalty

Supplier trade credit plays a crucial role in maintaining strong relationships with buyers and preventing them from seeking alternative suppliers. Trade credit relies on trust, effective communication, and a mutually beneficial relationship between the supplier and buyer. 

Disadvantages of Trade Credit

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 Disadvantages of Trade Credit for the Client

While the disadvantages of trade credit for buyers are fewer compared to suppliers, it is still important to be aware of potential drawbacks.

Challenging for Startups

Although trade credit may appear beneficial for startups, it can be difficult for new businesses to obtain. Suppliers may be hesitant to offer trade credit to businesses without an established track record or consistent trading history. Additionally, trade credit for startups may come with restrictive repayment terms, limiting its accessibility.

Penalties and Interest

While trade credit initially seems like "free money" that can be repaid without interest, late or missed repayments can result in penalties and accrued interest. Failing to meet repayment deadlines can quickly turn trade credit into expensive debt, leading to significant costs for the buyer.

Legal Consequences

Falling behind on trade credit payments can lead to legal action against the buyer. This may result in court judgments that adversely affect the buyer's credit rating. In some cases, suppliers include a "retention of title" clause in the trade credit terms, allowing them to reclaim the goods they supplied if any payment is missed.

Negative Impact on Credit Rating

Missed deadlines and late payments can quickly damage the buyer's credit rating. This can have implications when the business seeks future financing options, such as small business loans. A poor credit rating may increase the amount of interest charged or even hinder the ability to secure a loan.

 Loss of Suppliers

Suppliers may choose to discontinue working with a buyer who consistently struggles with payment. This can result in a loss of vital business relationships, leaving the buyer unable to operate or meet customer demand.

To be on the safe side, 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 businesses 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 Disadvantages of Trade Credit for the Supplier

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.

Suppliers face several challenges and risks when it comes to offering trade credit, which can have negative impacts on their operations and finances.

Risk of Late Payments

One of the major drawbacks suppliers encounter when offering trade credit is the issue of buyers paying late. Depending on the industry, it is common for buyers to delay payments, causing inconvenience and potential cash flow disruptions for suppliers.

Cash Flow Difficulties

Late or non-payments by buyers can lead to significant cash flow problems for suppliers. Balancing the need to settle their own outstanding bills with the task of chasing overdue payments from buyers can create financial strains. It is important for suppliers to maintain a strong cash reserve and avoid overextending on credit.

Risk of Bad Debt

While late payments are concerning, non-payment presents a more serious challenge. If a buyer uses trade credit and can’t pay, suppliers may have to write off the debt as bad debt.

Customer Assessment Challenges

Offering trade credit requires suppliers to assess the creditworthiness of their customers. Evaluating whether a customer has the means and reliability to repay the credit involves conducting thorough checks such as verifying references, obtaining credit reports, and reviewing trading history.

Administrative Burden

Implementing trade credit involves significant paperwork and administrative tasks. Suppliers may benefit from seeking professional legal assistance to draft comprehensive terms and conditions. Additionally, dedicated account handlers are necessary to ensure timely follow-up on outstanding invoices. Establishing clear invoice terms and maintaining effective communication can encourage buyers to make prompt and regular payments.

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.