How Do Businesses Use Trade Credit to Order Inventory?
Trade credit refers to an arrangement between one business (the customer) and that business’s inventory or raw materials supplier (the vendor). The customer buys goods or services but pays the vendor at least one month later. This mutually-agreed-upon due date usually ranges from 30 to 90 days after the customer places the order. All sorts of businesses (big and small) use trade credit because they often cannot afford to pay the full cost of the inventory at the time in which they need to order it.
Ordering Inventory with Trade Credit: Example
Every business spends money to make money. Well, many businesses have to spend an above-average amount of money, and they don’t make that money back until several months have passed. This cycle repeats itself because during those months, the business has to keep spending money.
For example, let’s say your new business designs, creates, and sells handmade jewelry. Each item consists of numerous materials, on top of other expenses like crafting tools, packaging, etc. Materials and packaging must be bought in bulk immediately, but you don’t expect customer interest to peak until at least two months from now. Compared to your other expenses, it’s clear that the materials for making your items will cost the most. So, it’s up to you to figure out how to pay for them and choose the most sensible option.
As stated earlier, these options include credit cards, short-term business loans, or even using your own money. But before you choose, you might as well check if any suppliers will send you the materials now with 90 days of trade credit. This will give you enough time to create and sell enough items to generate plenty of revenue. In three months, you’ll have enough money to pay back the vendor while continuing to fund your business. You might even generate enough revenue in two months to pay back the vendor early and prove that you can accommodate similar (if not longer) credit terms in the future.
As you can see, trade can work very conveniently for younger and smaller businesses.
What are Common Terms Used in Trade Credit Agreements?
The formality of trade credit partnerships depends on the vendor. In most cases, however, you don’t have to expect the same formalities associated with small business loans, like credit checks or personal guarantees. The order invoice itself will likely act as the agreement’s sole form of documentation. It should contain the full terms of the deal, which includes the due date, along with the vendor’s policies for delinquent payments and early payments. Many vendors offer discounts for early payments or simply for paying on time (we’ll explain why in a bit).
The phrasing of some common terms can be confusing, but you need to know their meaning because they can also be very indicative of the nature of the partnership.
Here are those terms followed by their definitions:
Vendors that require cash-based invoicing expect payments for orders before or at the time of the order’s delivery. In other words, these vendors usually do not offer trade credit. Any vendor that uses point of sale systems (cash or credit card-based) requires cash-based invoicing.
But you probably won’t see the term “cash-based invoicing” on the vendor’s website or in their invoices. Instead, the vendor will likely use one of the following terms to indicate this invoicing system:
Paid in Advance
This means the customer must pay before the order gets shipped.
Cash on Delivery
Not only must the customer pay upon receiving the order, but that payment must be cash.
Due on Receipt
The customer must pay immediately after receiving the invoice.
Trade Credit Invoicing
Like cash-based invoicing, vendors that offer trade credit probably won’t use this exact term on their website or invoices. Instead, they will communicate this policy by attaching the word “net” next to the length of credit they extend. For example, you might see an invoice that says “Net 30” or “Net 45.” This means the payment is due 30 or 45 days after the customer receives the invoice.
Most vendors that offer trade credit use Net 30 invoicing terms, which is essentially the minimum amount. Still, you should not assume that your newest vendor uses 30-day terms like everyone else. Before placing your first order, ask about the vendor’s standard invoicing terms. This way you can get all the negotiating out of the way now, rather than in the middle of an order.
Do Trade Credit Agreements Include Interest?
Trade credit agreements usually do not include interest. But to protect their cash flow, vendors will use other strategies that increase the likelihood of getting paid on time while maximizing profitability on each sale. For this reason, virtually every trade credit agreement comes with some sort of extra cost. This makes sense because the agreement allows you, the customer, to save money by paying when it’s more convenient for your cash flow as well.
Let’s look at two very common ways vendors add extra costs onto trade credit agreements:
Cash or Prompt Payment Discounts
Vendors that issue 30 or 45-day invoice terms tend to offer discounts for cash on delivery or simply paying on or before the requested due date. For example, one vendor might offer 5% discounts for customers who pay less than two weeks after being invoiced, while another vendor might offer the same discount for customers who just pay within the requested 30-day time frame.
These two discount strategies aim to attract more customers, and they often achieve their goals. Many customers have no problem paying in less than 30 days. But when you really think about the total price of the products, the customer isn’t receiving as much of a “discount” as they imagine.
You have to remember that vendors choose their prices. Those that offer discounts for timely or early payments set prices that account for these benefits, along with their standard terms (Net 30, etc.). In other words, the vendor bases the price on the likelihood of their customers receiving the discount. If most customers receive the discount, then the “discounted” price is essentially the real price. Customers that don’t receive the discount think they are paying the real price when in reality, they are paying more for using more trade credit.
You probably won’t find a vendor who allows customers to pay less than the product’s real price. Such a policy would destroy profitability surely lead the vendor into bankruptcy. So, never forget that regardless of incredible the discount sounds, you always have to pay for trade credit.
Late Payment Penalties
Vendors charge late payment penalties because just a few late payments can do serious damage to their cash flow. Many vendors have even found that if they don’t include late payment penalties on their invoices, the customer literally ignores the invoice’s due date.
Common late payment penalties range from 10% to 15%. Automated invoicing systems use this range because it has had considerable success in getting customers to pay on time. Some vendors will report certain amounts of late payments (consecutive or not) to the major credit bureaus, which could hurt your business credit and make it very difficult to secure future trade credit agreements.
As you can see, you should avoid late payments at all costs. If you cannot afford to pay on time, contact the vendor well before the due date, explain your financial issue, and offer a solution. Any experienced vendor knows that responsible business leaders run into cash flow problems all the time. If the issue stems from uncontrollable factors and you reach out before the last minute, your vendor will likely understand and either decrease or waive the penalty.
How Can You Use Trade Credit to Your Advantage?
Using trade credit to your advantage protects your cash flow as well as the partnership. To do this, you must work with the right vendors and make wise decisions when placing orders. This will ultimately ensure that you always have the resources to pay on time.
Follow these tips to steer clear of late payment penalties and unfavorable terms:
Work With Smaller Vendors
Younger, smaller businesses often have trouble securing trade credit from large vendors. First-time customers of large vendors (big or small) might have to pay steep upcharges for any trade credit, even as little as Net 30. You could try to negotiate but it’s usually very difficult to get in touch with owners of large businesses. Thus, it’s unlikely that you’ll have the opportunity to explain yourself after one of the aforementioned cash flow issues.
Smaller vendors, on the other hand, tend to offer much more realistic terms, especially for their similarly-sized peers. You can speak to the owner directly and likely negotiate an agreement that conveniently suits your cash flow cycle. Fellow small business owners will also show more compassion if you pay late or need an extension.
Don’t Place Inventory Orders Too Far Ahead
The ideal amount of trade credit allows you to place orders shortly before you sell or use the products to generate revenue that offsets their cost. This maximizes profitability by reducing the amount of time in which your business spends money while making much less. You can accomplish this by refraining from placing orders too early and letting products go unsold for months on end.
Let’s go back to our hypothetical handmade jewelry business from the beginning of this guide. In order to minimize the amount of time between ordering and using the materials, you should plan out your different designs and purchase the other necessary expenses before placing the orders. When the orders arrive, you’ll have everything you need to create and ship your items as soon as possible.
This scenario should explain why owners of apparel/accessory businesses order inventory at such a high pace: to put their materials to use immediately after they arrive. The longer inventory or supplies sits on your shelves, the longer it will likely take you to pay back your vendor.
What is Last Minute Inventory Management?
In addition to timing your orders correctly, you should make sure to only purchase appropriate quantities. Vendors often give discounts for bulk orders, but ordering too much inventory can cause much more damage than ordering too little. Unused inventory dramatically limits your supply of available working capital, which you need to pay your vendors.
You can avoid purchasing too much inventory by taking extra measures to improve the forecasting of demand. Many businesses don’t place orders until they have accumulated enough data to support the investment. It takes time to accumulate this much data but it leaves you with very little unused inventory. They sometimes order the inventory just days before it gets sold, hence the nickname “last minute” inventory management.
Allow Customers to Pre-Order
You may have noticed the growing number of businesses that allow customers to pre-order products before their official release. These businesses aren’t just doing this to generate more buzz. Pre-ordering also helps the business in at least two additional ways: First, it gives the business revenue to begin paying back their vendors well before the full payment’s due date. Second, pre-ordering gives the business valuable data in regards to demand for the actual release. The number of pre-orders provides an estimate for the amount of inventory the business needs to satisfy the upcoming demand.
Businesses looking to improve demand forecasting should, therefore, consider the pre-ordering model. You can offer customers discounts, freebies, or early access to future releases. Some vendors might even offer discounts for early payments from pre-order revenue.
Streamline Accounts Payable Processes
Great trade credit management ultimately comes down to paying your vendors as quickly as possible but not so quickly that it hurts your cash flow. This becomes much easier when you streamline your accounts payable process or the process of paying your vendors. Numerous software tools can help you pay bills by the due date, keep track of each vendor’s discount policies, and most importantly, never forget to pay on time.
Small businesses with only a few vendors can probably stay organized with an accounts payable spreadsheet. As your business grows, however, you should look into tools like Xero and Quickbooks. The boost in efficiency can allow you to waste less time on manual tasks and focus on making more sales.
Keep Cash Reserves
Every small business owner knows that no matter what you do, external circumstances can arise out of nowhere and cause gaps in cash flow. Businesses that use trade credit should prepare for this inevitable scenario by keeping at least one month’s supply of accounts payable on hand. The hard part isn’t putting money away to create this cash reserve. It’s resisting the urge to dig into it when presented with an early payment discount or another opportunity to save on an order. You must continuously remind yourself that this money is meant for just one purpose, and that’s getting you out of a cash-flow gap.
How Does Business Credit Affect Trade Credit?
Vendors often decide which businesses to work with by looking at business credit, which represents credit activity that is tied to the business itself. Much like your personal credit score, the number one rule for maintaining a great business credit score is to pay your vendors on time. But you’ll have to do more than that to ensure that you are building business credit as you make payments. Here are two additional requirements for building business credit:
Pay Business Expenses with Business Credit Card
Paying your business’s bills on time will do nothing for your business credit if the payments come from a personal account. These payments must come from an account in your business’s name or a business credit card. Using a personal credit card for this purpose can damage your personal credit score, which is why the requirements for business credit cards have loosened as of late.
Register as Independent Company
Registering your business as an LLC or corporation separates your business’s debts from your personal credit. Your business can now take on more debt without affecting your personal credit score, which would certainly plummet from the amount of debt carried by the average small business.
Registering your business also spares your personal credit score from harm in the event of an unforeseen crisis. If you were suddenly unable to pay your bills, your business credit would take the hit. This is extremely advantageous because a logistical response to such an event is taking out a small business loan. Getting approved for the amount of money you need will likely be much harder with a low personal credit score.
What are the Best Business Loans for Ordering Inventory?
Before you start comparing different types of business loans, you must first consider the price of the inventory. Your industry’s typical items may be significantly cheaper than most other industries. Your business might also place smaller orders, possibly due to the size of your business or the fact that selling retail items is just one of your various revenue streams.
If either of these scenarios sounds like your business, the best financing option for purchasing inventory might be a business credit card. Business loans only make sense for purchasing expensive items or large orders. If you used a business credit card for such an order, your interest and monthly payment would skyrocket.
Traditional business term loans also probably don’t make sense for inventory financing. Think about it. The main advantages of a business term loan are the high borrowing amount and lengthy terms. Odds are, the borrowing amounts associated with business term loans greatly exceed the cost of your inventory. If you borrow too much, you might have to use operational funding or your savings to pay it back. And as we’ll explain in the following section, the terms of the business loan should directly coincide with the new inventory’s impact on your cash flow. Business term loans usually carry terms of at least 1-2 years. Who knows what your revenue will look like so far down the line?
What is the Purpose of the Loan?
Once you’ve ascertained that a business loan is the right choice, the next step is to determine the purpose of the loan. After all, businesses use business loans to purchase inventory for a variety of reasons. Maybe you need to continue purchasing items on a consistent schedule, but your usual cash flow cycle has been disrupted. Maybe you’ve ordered inventory and your cash flow hit a roadblock shortly after. It could take at least three months to recover, and that’s way past the order’s due date.
Many seasonal businesses use business loans to stock up for the busy season in the months beforehand. Some vendors offer very limited discounts during this time because it’s a slow season for their businesses, too. You might be able to save big by paying upfront and ordering in bulk.
Why is the purpose of the loan so important? Because it determines when the revenue generated by the order will start coming in. This time frame will give you an idea of which loan repayment structure would be most conducive to your cash flow.
Should You Use a Business Line of Credit to Order Inventory?
A business line of credit is designed for businesses that strive to practice the aforementioned “last minute” strategy. It also comes in handy for businesses that frequently purchase unusually large orders.
To understand the advantages of a business line of credit, think of it as a credit card with lower interest and higher spending power. Like a credit card, you can draw from your credit line at any time. And once you pay back what you owe each month, that amount becomes available again. But unlike a credit card, your interest rate won’t skyrocket, and your credit score won’t tank when you make large purchases.
A business line of credit essentially allows you to respond to changes in demand immediately, rather than just making educated guesses about quantity months beforehand. If you need to act this quickly again in a few months, you won’t have to take the time to apply for another loan. The credit line replenishes every time you pay off your balance.
In summary, a business line of credit is best for businesses that don’t just buy the same amount of inventory twelve months a year.
Other Options: Merchant Cash Advance
A merchant cash advance may be a better option if you can meet the following three pieces of criteria. First and most important, most of your customers must pay via debit or credit card. Second, you must have a clear idea of how much inventory you’ll need, based on accurate upcoming sales projections. Lastly, your business must be gearing up for a busy season that begins in just a few months.
Why do these requirements matter so much? It’s because a merchant cash advance has a unique repayment structure. Payments are deducted as a percentage of daily debit and credit card sales. And unlike a credit card or business line of credit, your principal doesn’t increase over time.
For this reason, a merchant cash advance is best for highly seasonal businesses. You know how many sales you will make based on last year’s numbers. What you don’t know is exactly when the majority of those sales will take place, and how long it will take to reach your revenue goals. If you used another business financing product, these circumstances would either increase your interest rate or force you to make monthly payments during your slow season.
Other Options: Short-Term Working Capital Loans
You may conclude that the traditional repayment structure of a business term loan makes the most sense for your cash flow. And maybe the situation that caused the need for funding won’t arise again anytime soon. In this case, you should probably explore short-term working capital loans. This solution is typically only recommended for isolated incidents, or when cash flow crunches are relatively rare.
Compared to other financing products, short-term financing has higher interest rates and higher monthly payments. But with terms under one year, the monthly payment schedule might perfectly coincide with a solid and consistent revenue stream. And you probably don’t need enough inventory to warrant the high borrowing amount and longer terms of a traditional business term loan.
Also, short-term financing carries some of the loosest requirements of any financing option on the market. The borrowing power for the other two options depends on your business’s financial health. With short-term financing, your cash flow doesn’t need to be in the greatest shape either.
What is Inventory Financing?
Inventory financing involves using existing inventory or an upcoming order as collateral to obtain business funding for another purpose. This makes inventory financing a form of asset-based lending.
Inventory financing is particularly ideal for businesses that must pay their suppliers in a shorter period of time than it takes them to actually sell the inventory.
What are the Benefits of Inventory Financing?
Funds from inventory financing can be used for a myriad of purposes, such as:
- Getting through a temporary, unexpected cash crunch
- Boosting short-term working capital to support daily operations
- Keeping fast-selling merchandise in stock
- Taking advantage of vendor discounts for purchasing a larger volume or paying up front
- Taking advantage of off-season discounts
- Purchasing extra inventory to avoid going out of stock. Since demand is so difficult to predict, small retailers often find themselves in short supply of their most popular products. And when the busy season arrives, it can be nearly impossible to re-order at the last minute. With inventory financing, you can stock up on everything that seems to be gaining traction.
- Taking advantage of a time-sensitive new opportunity. For example, you just got word that Costco is finally interested in your product. But they require large quantities, and on a constant, recurring basis. You need more inventory to ramp up production right now, or you’ll lose that amazing sale.
Which Businesses are Good Candidates for Inventory Financing?
You’re a good candidate to finance your inventory if:
- The products sell quickly
- Your business has a solid sales history
- Your busy season is approaching
You’re not a good candidate if:
- Your business has lots of existing debts
- You want long-term financing
- You want to purchase new products that have no verifiable sales history
The type of inventory matters as well. Different types of inventory are easier or harder to sell in the event of default. This is reflected in the inventory’s liquidity. The easier it is to sell, the more of its value you can borrow.
However, this also makes inventory financing accessible to borrowers with bad credit. If the inventory is easy to sell, business lenders may be willing to overlook your bad credit since they have a way to make up for the potential loss. This decreases the heightened risk typically associated with bad credit.
Making Your Decision
Once you’ve found the right product for your business, you can focus your attention on the myriad of financial institutions that provide them. But with so many institutions to choose from, how could you possibly pick one? You can narrow your search by asking institutions about prior experience with your industry. Institutions that are familiar with your cash flow cycle will not present offers that will impede your ability to pay other bills. Much like your vendors or suppliers, strong relationships with financial institutions are crucial for growth. Well, it’s much easier to initiate such a relationship when the institution has worked with plenty of other businesses facing the same challenges as yours.
Which inventory management tactics have been most effective for your business? Share any solutions or resources on our contact page!