Making use of trade credit
Maybe you've heard of it: trade credit. It is an essential part of capitalism. It is a critical source of capital for a majority of all businesses. But what is trade credit and how can you make use of it?
First, a definition: Trade credit is a company's open account arrangements with its vendors. It is when one firm or company provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. Vendors and suppliers will often sell on credit and this kind of financing is common for both starting and growing businesses. Trade credit is the largest use of capital for a majority of business to business sellers in the United States
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What can it do for you? It is especially important in operating a business. It can reduce the required capital investment to operate the business if it is managed properly.
Let's look at an example. According to wikipedia.com, Wal-Mart, admittedly the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings. Trade credits for Wal-Mart are 8 times the amount of capital invested by be shareholders and is their second largest source of capital (with retained earnings as the largest amount of capital).
Different industries use different kinds of trade credit. There are many forms available for common use. But they all share the same thing in common: the collaboration of businesses to make efficient use of capital to complete certain business goals.
To understand this more fully, let's imagine that you own and operate a hot dog stand under a franchise. The franchise agrees to provide you with hot dogs under the terms Net 60 with a fifteen percent discount on payment within 30 days, and a twenty five percent discount on payment within 10 days, meaning you have 60 days to pay the invoice in full. If you sell enough hot dogs at your markup price within the first week, you can send a check for 80% of the invoice and make an extra 20% on the hot dogs that you sell. But if sales are slow then you may decide to pay 90% within 30 days or use the money for another 30 days and pay the full amount within 60 days instead.
So how does this help you? Well, in the example of the hot dog stand, you are given the money to run your business on credit. However, you are given incentives to pay back the money as fast as possible (the 15%-25% off if you send in the money earlier), and no penalties for sending it in right on time. The major advantage of trade credits is that it is often very available. It allows you to spread your payments over a period of months or even years with minimal or no down payments or interest charges.
Be aware that when you use trade credit, you are probably paying a higher purchase price. Vendors often experience the same type of cash flow pressures that a small business does and may offer discounts for immediate cash payment. By purchasing on credit, you eliminate the cash discount and pay a higher relative price for your goods.
So how can you make the most of trade credit? Use it. But use it sparingly. If your business is doing well and you have the cash to purchase your goods, use the cash. Be careful of getting into serious debt when using trade credit. Just because the money is free upfront doesn't mean there won't be penalties later (if you don't pay on time, for example).
