After figuring out your general strategy and business model, it’s time for the least fun part of starting your own business: calculating startup costs. There’s equipment, marketing, and office space, but these expenses pale in comparison to the cost of your initial supplies of inventory. New businesses must provide exemplary customer satisfaction in order to build loyalty. It’s very difficult for retailers, wholesalers and even restaurants to accomplish this without buying massive amounts of inventory.
Your inventory expenses may very well exceed your current budget. So, how will you pay for it? The first options that come to mind might include business loans, lines of credit, or business credit cards. But then it dawns on you: Why not just ask for trade credit?
Trade credit makes perfect sense for businesses that regularly place bulk orders with outside vendors. Instead of accruing debt from credit card companies or business lenders, trade credit allows the source of the inventory to finance your orders.
In this guide, we’ll explain the different types of trade credit, how to use trade credit to your advantage, and how to prevent trade credit from damaging your cash flow.
What Is Trade Credit?
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.
Trade Credit: An 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’ time, 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/or smaller businesses.
Understanding Invoicing Terms With 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 agreement, 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 about 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 so you can get all the negotiating out of the way now, rather than in the middle of an order.
The Cost of Trade Credit
Trade credit agreements usually do not include interest. But in order 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 goal. Many customers have no problem paying in less than 30 days. But when you really think about 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 own prices. Those that offer discounts for timely or early payments typically 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.
Tips For Using 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 hazardous 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 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 usually work at such furious paces: 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.
Only Buy Enough To Satisfy Demand
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 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 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.
Look Into Business Line of Credit
Even if you have no trouble paying your bills on time, you may still feel like your spending power is restricted. Some opportunities are just too good to pass up, and they tend to arise at the most inconvenient times for your finances. This common dilemma can be solved by a business line of credit, which you can borrow from at any time.
Business lines of credit are especially advantageous for the aforementioned “last minute” inventory strategy. Forecasting demand can be so difficult that you don’t know exactly how much inventory to purchase until sales start coming in. With a business line of credit, you can respond to changes in demand immediately, rather than just making educated guesses about quantity months beforehand.
Young businesses can also use lines of credit to establish partnerships with large vendors that are hesitant to give trade credit. Thanks to companies like United Capital Source, young businesses can easily get approved for business lines of credit along with other financing options like term business loans or equipment financing. You just have to figure out how you want to use the funds: to pay the vendor, or cover your other business expenses before the revenue comes in?
Trade Credit and Business 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.
Trade credit provides the biggest advantages of short-term financing without the costs of taking out a loan. You just have to work with the right vendors and do what’s necessary to follow their terms. Making wise choices in these areas will keep your cash flow safe as your business grows!