Trade credit forms an essential part of a business by enabling growth and access to finance –especially for smaller businesses. However, trade credit also brings with it credit risk. Here, we explain how trade credit works and how businesses can protect themselves against the risks involved in using trade credit.
What is trade credit?
Trade credit is the world’s single largest source of business finance and an important tool to enable business growth. Simply, it is an arrangement between businesses where a supplier allows a customer to purchase goods or services on credit, and pay for them at a later date. This is typically 30, 60 or 90 days after invoicing.
Trade credit is a common form of short-term financing and plays a crucial function in the economy. It enables companies to receive the goods or services they need and then sell on their goods or services, using the net proceeds to pay back their debt to the original supplier. Without trade credit, new businesses may struggle to raise enough finance to operate initially.
What is credit risk?
Because the customer is able to purchase goods or services on credit and pay for them at a later date, this creates a risk that the supplier may not receive payment. This risk is labelled ‘credit risk’. As supply chains are inherently linked, if a business fails to manage its credit risk effectively and suffers from insolvency as a result, this can cause a domino effect throughout its own supply chain. Companies therefore have a responsibility to their trading partners, as well as themselves, to manage risk responsibly. Those that successfully balance credit risk should be able to maximise sales opportunities while preserving their liquidity.
What are the advantages and disadvantages of trade credit?
Trade credit offers numerous advantages as it enables business to access working capital finance at low-cost, and with generous repayment conditions. It can fuel business growth and be of particular benefit to small and medium sized businesses. For businesses with a positive credit history, agreements are typically easy to arrange and maintain, as long as repayment conditions continue to be met.
Another advantage is that trade credit is accessible to most types of businesses, and supply chains are protected by late payment regulations.
One disadvantages of receiving trade credit is that, if a business fails to comply with payment conditions – if it suffers from cash flow problems for example – it could lose its suppliers. In addition, some businesses, such as online retailers, may not be able to access trade credit, while customers may ask for favourable trade credit terms, putting pressure on cash flow.
How is trade credit agreed?
Trade credit is agreed between the supplier and purchaser, with the supplier typically determining the payment terms. For example, due to its reduced capital reserves, a small business may offer shorter terms or require a 50 percent payment upfront. Payment terms may also differ between sectors. For example, jewellery businesses may extend credit for 180 days or more. Due to their size and purchasing power, larger businesses have greater power to determine their payment terms to suppliers, which can be problematic for small businesses with tighter cash flow.
To reduce their credit risk, businesses often use credit rating agencies to determine how much credit to extend to customers. New customers may be offered more stringent credit terms, which then become more flexible over time. In order to encourage good payment practice, suppliers may levy interest on late payments or offer reductions for early repayments.
What is trade credit insurance?
To reduce credit risk exposure, businesses may take out trade credit insurance. This is a risk management product that helps businesses safeguard their accounts receivable from non-payment by customers, protecting the business against insolvency or bankruptcy. It is typically paid for on a monthly basis and calculated as a percentage of sales.
There are different types of trade credit insurance policies. These can range from accounts receivable insurance to protect against individual or multiple customer non-payment, through to export credit insurance, which protects customers against the negative impact of political events on their accounts receivable.
How should I protect against trade credit fraud?
Businesses should guard against customer payment defaults due to insolvency or other financial strains. But they should also guard against trade credit fraud. This occurs when fraudsters mislead companies into extending a line of credit, and then fail to repay it once they have received the goods or services.
Companies can protect themselves from trade credit fraud by implementing robust risk management policies and processes, and ensuring employees are well trained in detecting fraud.
Operating an effective due diligence process is a key part of successful trade credit fraud prevention. This involves researching customers and prospects thoroughly, verifying company information and researching customers’ reputations within their supply chain. Credit rating agencies like Graydon also offer fraud prevention services, utilising an extensive customer database to highlight potential red flags in trade credit applications.