Trade credit is an essential tool in modern business, allowing companies to manage cash flow and strengthen supplier relationships. This guide delves into the nuances of different trade credit types, each catering to specific business needs and scenarios.
Why you need to offer trade credit
While COVID-19 put the world on pause, some positive advances in the B2B space emerged. The BNPL B2C model is making its way over to B2B and now, more and more business customers are expecting an experience akin to their B2C purchases.
This can be partly explained by how familiar B2B buyers are with financial technology. Given 73% of all professional B2B purchasing decisions are made by millennials, the increasing assumption is that B2B companies will offer the same seamless purchasing experience as B2C.
And that includes offering net terms. For example, a study by McKinsey found that 96% of B2B buyers might make a purchase in a fully end-to-end, digital self-serve model. Offering trade credit becomes not just preferable but expected by B2B buyers and one of the leading reasons you should offer B2B trade credit solutions.
Types of trade credit
Open Account trade credit is the most common type of trade credit, typically involving an invoice and a promissory note as primary documentation. An Open Account is preferred in long-standing business relationships where mutual trust has been established. Although it's less secure for sellers due to the lack of formal guarantees, it can streamline transactions and strengthen business ties.
Businesses often use this method to foster loyalty and long-term collaboration. However, it's important for sellers to conduct thorough credit checks and possibly leverage credit insurance as a safeguard against potential defaults.
Benefits: Strengthens business relationships through trust. It's efficient and cost-effective, reducing administrative burdens.
Risks: High risk for sellers due to lack of formal payment guarantees. Potential cash flow issues if the buyer delays payment.
Trade Acceptance is vital in global trade, offering a formalised agreement that reduces ambiguity and enhances trust. It involves a legally binding draft that both parties sign, confirming the terms of the transaction.
This type is especially beneficial for businesses engaging in international trade, where long-distance transactions necessitate clear, enforceable agreements. It's crucial for companies to understand the legalities involved to protect their interests.
Benefits: Provides a clear, formal agreement that enhances trust, especially in international trade. It can improve documentation and financial planning.
Risks: Relies heavily on the buyer's willingness and ability to honour the agreement. Legal complexities may arise, especially in cross-border transactions.
Cash-on-Delivery is a straightforward, low-risk option primarily used in domestic transactions. It's most effective in industries where immediate payment upon delivery is practical and minimises the risk of bad debt. While it ensures immediate cash flow for the seller, it might not always be viable for buyers who require time to generate revenue from the sold goods.
Benefits: Minimises the risk of non-payment for sellers. Ensures immediate cash flow upon delivery of goods or services.
Risks: May not be feasible for all buyers, especially those who need time to generate revenue from the sold goods. Limits buyer's cash flow flexibility.
Revolving Credit offers a flexible line of credit to buyers, similar to a credit card system, but in a B2B context. It's beneficial for companies requiring ongoing purchasing power. The key advantage is the ability to manage cash flow effectively, but it requires the buyer to maintain a good credit discipline.
It's a dynamic tool for businesses that have variable purchasing needs. Revolving Credit offers a flexible line of credit to buyers, similar to a credit card system, but in a B2B context. It's beneficial for companies requiring ongoing purchasing power. The key advantage is the ability to manage cash flow effectively, but it requires the buyer to maintain a good credit discipline. It's a dynamic tool for businesses that have variable purchasing needs.
Benefits: Offers flexible payment terms for buyers. Enhances purchasing power and aids in managing short-term liquidity needs.
Risks: Requires disciplined credit management from the buyer. Mismanagement can lead to excessive debt and financial strain.
Instalment Credit is structured with an initial down payment followed by scheduled payments. This arrangement is suited for high-value transactions, offering a predictable payment plan. It can assist buyers in budgeting and cash flow management but requires careful planning to ensure that instalments are met on time to avoid penalties or strained supplier relationships.
Benefits: Allows buyers to spread payments over time, aiding in budget management. Useful for high-value transactions.
Risks: Default risk if the buyer fails to make timely payments. Can lead to strained business relationships and potential legal action.
Consignment arrangements are unique, with the supplier retaining ownership of the goods until they are sold by the buyer. This method is prevalent in retail and is beneficial for products that may not sell immediately. It reduces inventory costs and risks for the buyer but requires a strong trust bond and clear terms regarding unsold inventory handling.
Benefits: Reduces inventory risk and upfront costs for the buyer. Ideal for products that might not sell immediately.
Risks: Puts more financial pressure on the supplier. Unsold goods can lead to disputes over inventory handling and costs.
How to choose the right trade credit type
Selecting the right trade credit type is a crucial decision for businesses, impacting cash flow, risk management, and relationships. Here are key factors to consider:
1. Assess Your Financial Health: Understand your cash flow situation. If your business requires immediate cash post-transaction, options like Cash-on-Delivery might be preferred.
2. Evaluate Your Relationship with the Buyer: Long-standing, trust-based relationships might be more suited for Open Account trade credit. For new or less certain relationships, secured options like Trade Acceptance are advisable.
3. Consider the Transaction Size and Frequency: For larger, infrequent purchases, Instalment Credit might be appropriate. Revolving Credit might suit businesses with frequent, variable purchasing needs.
4. Understand the Risk Profile: Assess the risk tolerance of your business. Higher-risk options might offer better growth opportunities but require more stringent risk management.
5. Legal and Compliance Aspects: Ensure that the trade credit type aligns with legal requirements, especially in international trade.
6. Industry Norms: Consider common practices in your industry. Some industries might favour certain types of trade credit due to the nature of transactions.
By carefully considering these factors, businesses can choose the most appropriate trade credit type that aligns with their operational needs and strategic goals.
Alternatives to trade credit
Trade credit (and the different versions of trade credit) can be used to a company's advantage depending on their needs, future goals, and resources. But trade credit isn't for everyone. In fact, the rise of B2B BNPL has driven many businesses to offer their customers this alternative form of financing. Learn more about alternatives to trade credit here!