Trade credit – definition
The principle of operation is trivially simple – it is the seller who grants trade credit to the buyer. The parties agree to a deferred payment by writing a corresponding contract between themselves. The popularity of this method of lending is largely influenced by the fact that trade credit requires an absolute minimum of formalities – a contract specifying the terms of the agreement is sufficient.
EXAMPLE
Ms. Susanna, who runs a sole proprietorship, orders products for her sculpture studio from a wholesaler. He is currently awaiting payment for several orders, in view of which he does not have the funds to make up the shortfall. As the cooperation between Ms. Susanna and the wholesaler has always been successful, there is no problem with obtaining trade credit. The parties agree that the entrepreneur will pay for the delivered goods within 30 days from the date of delivery of the goods, and write a contract. A trade credit has just been concluded.
Reverse trade credit – what is it?
A variation on the theme of trade credit is its inverted version. This means that the seller of goods or the provider of a service receives an advance payment or even the entire amount from the buyer even before the order is fulfilled. In this situation, too, the exact date of delivery of the aforementioned should be specified in the contract drawn up together. goods.
Trade credit – advantages and disadvantages
What distinguishes trade credit from – for example – a bank loan is the simplicity of handling and speed of execution. Moreover, the cost of trade credit is usually lower than the loan we take from a bank.
If this is the first time you’ve read about trade credit, up to this point it may seem like a no-fault solution. But don’t kid yourself – such a method of financing also has its drawbacks.
First of all, not everyone can count on getting trade credit. In the example mentioned above, the situation between Ms. Susanna and the product supplier was clear – they had worked together in the past, they have shared experiences and they were positive. However, a similar relationship has to be developed, and it often takes years. At the end of the day, trade credit is based on a considerable amount of trust in the counterparty.
As if a consequence of the above is the merchant limit. This is a term used, for example, by insurance companies, which in some situations advise businesses that plan to extend trade credit to their contractors. A buyer’s limit is the maximum amount of credit that a seller can extend and, in the event of repayment problems on the part of the buyer, be compensated.
Important!
The amount of the trade limit may change as the relationship between the counterparties develops. If cooperation goes well, the limit amount will certainly increase.
It is difficult to count this as a disadvantage or an advantage, but an important feature of trade credit is the need to verify contractors. Of course, there is no provision mandating a background check on a potential borrower, but the practice is common and very legitimate. We can verify the contractor in debtor databases (for example, KRD).
Trade credit insurance
Speaking of insurance – trade credit can also be insured. The subject of the policy then becomes the receivables due to the seller. We can only purchase insurance on the condition that we also document the credit service itself.
Another way to protect against loss of funds is to include appropriate provisions in the loan agreement assuming the charging of interest for late repayment of the loan, or even the existence of a pledge or promissory note. The attractiveness of trade credit in this form diminishes somewhat for the buyer, but it gives the seller a greater sense of stability.
Trade credit vs. factoring
Trade credit will not be obtained everywhere and at all times – it is particularly popular with contractors who have been working together for a long time. So if, as I mentioned in the introduction: you don’t have the funds, you don’t have time to arrange a loan at the bank, and you have a relatively young company, it’s worth considering factoring.
EXAMPLE
Ms. Susanna, who owns a sculpture studio, is awaiting repayment from several clients, however – she needs to purchase materials for her work in order to be able to carry out further orders and maintain liquidity. Ms. Susanna was recently forced to terminate cooperation with her previous wholesaler, which significantly raised prices. In such an arrangement, a request for trade credit may be met with a refusal, so Ms. Susanna decides to sell the receivables to a factoring company and get the funds owed to her immediately – in exchange for the factor’s commission.
The principle of factoring outlined in the example above is the simplest explanation of this type of service. If you’d like to learn more about factoring and how it helps keep businesses afloat, take a look at this site PragmaGO Or read our guide: Factoring – what it is and what are its types, in which we explain in an accessible way what factoring is and how to take advantage of it.
Trade credit vs. bank credit
Most often, however, trade credit is compared to a bank loan, which seems obvious given the popularity of the latter. What most differentiates trade credit from bank credit is cost and time.
A bank loan tends to be more expensive than a merchant loan, due to greater complexity, more documents, more in-depth verification of the counterparty, the cost of servicing the obligation and the collateral used. All of this also affects the time it takes to get a loan.
In favor of the bank loan, however, is the ease of obtaining it – thanks to numerous legal stipulations, banks bear little risk when lending to their customers. What’s different is that merchants providing trade credit – first: they don’t make money directly from credit (the value lies in strengthening relationships with existing customers and establishing positive relationships with new ones), and second: they have to take care of the security of such a transaction on their own.
Which solution to choose?
As always, the answer is: it depends. However, let’s try to collect the advice from this article in the form of points:
- Trade credit is usually cheaper than a bank loan, requires few formalities, and the process of obtaining it is faster. However, this is not the safest option for vendors.
- A bank loan is safe, but requires a lot of paperwork, and the borrower can expect a fair check on his finances.
- Factoring is relatively easy to obtain, the process is instant, but in order to use it, we must have receivables.
