The Ultimate Guide to Trade Credit for Small Businesses

Trade credit—in which two parties agree to exchange goods or services without immediate payment—is a common form of business financing. Also called vendor credit or net terms, trade credit is typically used by B2B businesses, particularly those in the wholesale and manufacturing industries.

This being said, although trade credit seems like a simple enough financing arrangement, it’s important to understand how it works and how much it costs in order to determine if your business should extend trade credit to customers or receive trade credit from vendors.

Luckily, we’re here to help.

In this guide, we’ll explain everything small business owners need to know about trade credit—so that you can make informed financial decisions for your unique business situation.

What Is Trade Credit?

Trade credit is a financing arrangement in which a customer is allowed to buy goods or services now and pay for them later at a mutually agreed-upon date—typically 30, 45, 60, or 90 days in the future.

Also sometimes called placing an order on account, this informal credit relationship between vendor and customer is a great way for small businesses to order inventory or raw materials for resale without having to immediately outlay the cost of the goods.

Trade Credit Examples

To get a better sense of how trade credit works, let’s review a few examples:

First, let’s imagine you’re starting a business that designs, prints, and sells custom graphic T-shirts. To produce these products, you have to purchase an initial inventory of solid-colored T-shirts on which to print your designs, along with screen-printing equipment and supplies.

Before you can generate revenue on that product, you need to first obtain the supplies, print your T-shirts, and sell them, right? This is an example where you might use trade credit.

Instead of trying to acquire financing from a lender or alternative source, you might find a T-shirt vendor that will agree to send you an initial inventory of T-shirts now, with the understanding that you’ll pay for your order within 30 or 60 days—enough time to print and sell your T-shirts to generate revenue, some of which will go toward paying the vendor.

In this trade credit example, you, as the business, are receiving trade credit from a third-party, the T-shirt vendor. This being said, however, you might also find yourself in the opposite situation.

To this point, say, for example, you’ve been successful in your T-shirt business and you currently have a surplus of T-shirts made and ready to sell. A small boutique might come to your business and ask for an order of 100 shirts to sell in their store.

The boutique doesn’t have the funds on hand, however, to pay for the shirts, so you decide to send the inventory with the agreement that the store owner will repay you within 60 days—again, enough time for them to sell the shirts, generate revenue, and repay you. In this case, as opposed to being the business receiving trade credit, you’re the vendor extending trade credit to the boutique.

Understanding Trade Credit Terms

Now that you have an overview of what trade credit is, let’s discuss how this type of financing works in greater detail.

Overall, trade credit can be thought of as a form of debt financing, similar to a short-term loan. Unlike a traditional lender-borrower relationship, however, the agreement between a vendor and customer in a trade credit arrangement is typically much less formal.

Although some vendors perform credit checks on new customer accounts (and you should if you’re extending trade credit), not all do—and often the invoice itself is the only indication of a credit relationship.

Therefore, whether you’re extending or receiving trade credit, you’ll want to ensure that the terms of the relationship are indicated on the order invoice. These terms should include the invoice date, the due date of payment, along with any late penalties or discounts for prompt payment.

Net Terms

Generally, invoices issued on trade credit are issued as “net” followed by the number of days from the date of issue that the trade credit is extended. In short, therefore, the net terms on a trade credit invoice indicate how long you have to repay the vendor.

Typically, you’ll see one of the following invoice payment terms with a trade credit agreement:

• Net 30: Payment due within 30 days of the invoice date.
• Net 45: Payment due within 45 days of the invoice date.
• Net 60: Payment due within 60 days of the invoice date.

Although many vendors default to net 30 invoicing terms (as shown in the image below), you may see trade credit terms as long as 120 days. Additionally, as we mentioned, the trade credit invoice should also include information about payment discounts or late penalties. 

As an example, you might see an invoice with terms of 3/10, net 30. In this case, net 30 indicates that your payment is due within 30 days of the invoice date.

The “3/10,” on the other hand, indicates that you can receive a 3% discount if the vendor receives payment within 10 days of issuing the credit. You might also see this type of discount written as “3%/10”.

The Cost of Trade Credit

As it stands, trade credit may seem like an ideal financing option for your business—in essence, it’s equitable to an interest-free loan that you can use to free up cash flow. As we mentioned briefly above, however, there can be costs associated with trade credit—either in the form of discounts or late payments.

To this end, whether you’re receiving or extending trade credit, it’s important to understand how these costs work in order to determine if this type of financing agreement is right for your business.

Cash or Prompt Payment Discounts

As we described above, to improve cash flow and shore up their own cash on hand, vendors that routinely issue net 30 or net 45 invoices on trade credit sometimes include in their terms a percentage discount for cash on delivery or prompt payment of invoices. This could include terms such as a 5% discount on invoices paid within 10 days of issue, for example.

If your business is the one extending trade credit, these discounts are certainly advantageous—as they encourage your customers to pay you back promptly. On the other hand, however, if you’re receiving trade credit, you aren’t experiencing the same benefit.

In this case, the term discount is a little misleading. After all, the vendor is the one setting the prices on the merchandise. This means that they chose the price that they’re discounting from, most likely by determining a cash price, and then increasing that price by the amount of their payment discount to set a net 30, 45, or 60-day price. In reality, therefore, the early payment discount here is the real price of the goods, and the amount of the discount is actually your cost of using trade credit.

This difference might sound like semantics, but it should create an important distinction in your mindset as you consider purchasing goods from a vendor on trade credit. No matter the circumstances or the vocabulary used, trade credit is a form of debt—and debt always has a cost.

Late Payment Penalties

The other cost associate with trade credit is late payment penalties. When you’re receiving trade credit, late payment penalties will more than likely be included in your invoicing terms. And on the other hand, if you’re extending trade credit, you’ll want to ensure that you include late payment penalties in order to protect your business if the customer fails to pay on-time.

This being said, when it comes to these penalties, the price can be steep—sometimes as high as a 10% or 15% penalty on overdue invoices.

Of course, as a customer, you’ll want to avoid late payments at all costs—not only to avoid the fees but also to avoid damaging your relationship with your vendor, as well as avoid a history of late payments on your business credit report.

To this point, if you ever find yourself in a position where you might be forced to pay a vendor after the invoice due date, always contact the vendor in advance to explain the situation. Suppliers are far more likely to show understanding if you let them know what’s going on and offer a solution.

With this in mind, if you’re extending trade credit, you should be upfront with your customers about your late payment and credit reporting policies as well as how they can work with you to avoid any issues.

Pros and Cons of Trade Credit

Although trade credit is a common financial arrangement between B2B businesses, it is considered a form of debt financing, and therefore, it won’t always be right for every business nor every financing situation.

To this end, before you decide to take trade credit from a vendor, you’ll want to consider both the possible advantages and disadvantages of doing so:

Pros of Receiving Trade Credit:

• Easy to access: Compared to other forms of financing, trade credit is particularly easy to access, especially for startups or businesses with poor credit. As a relatively informal agreement, a vendor is unlikely to ask for the extensive documentation and qualifications that are often associated with typical business loans.
• Affordable: As long as you pay your invoices on-time, trade credit will be one of the most affordable forms of business funding out there. Plus, depending on the vendor you work with, you may be able to access a discount for paying early.
• Frees up cash flow: Instead of having to use your cash flow on hand to purchase suppliers or materials for your business, you can use trade credit—which frees up your cash flow to be used for other business purposes. Again, as long as you can pay your invoice on-time, this extra cash flow should allow you to serve your customers and run your business to the best of your ability.
• Can be used to build business credit: As we mentioned briefly above, trade credit can be used to help build or improve your business credit. Although not all vendors report payment history to business credit bureaus, many do (and you can ask your vendor about their policies). Therefore, as long as you have a history of paying on-time, taking trade credit can help build your business credit score.
• Builds a relationship with your vendors: Again, as long as you’re responsible when taking credit and you pay your invoices on-time, using trade credit can be a great way to build and solidify relationships with your vendors—which hopefully will lead to better prices and discounts in the future.

Cons of Receiving Trade Credit:

• Can be expensive: Whereas many of the advantages of trade credit are related to on-time payments, the majority of disadvantages are related to being unable to pay. First, if you are unable to make your payments on-time, trade credit can easily become an expensive form of financing—with steep late fees added on to your invoice.
• Can hurt your business credit: Similarly, if you can’t pay your trade credit invoice on-time, this can hurt your business credit. If your vendor reports a history of late payments, your business credit score will certainly suffer.
• There may be a cheaper or better-suited alternative: Although trade credit is generally affordable and easy to access, it won’t be the best-suited option for every business. For example, if you can’t pay your trade credit invoice on such short-terms, you might find that longer-term financing is a better and more affordable solution for your business.
• Can hurt your relationship with your suppliers: Finally, just like a history of on-time payments can benefit your relationship with your vendors, a history of late payments can damage your relationships. If you take trade credit and have trouble taking it back, your supplier may not want to work with you anymore—which leaves you having to find a new vendor.

On the other hand, of course, if you’re considering extending trade credit to customers, your business has a similar thought process to complete. You’ll want to weigh both the pros and cons of extending trade credit as a vendor to decide if it’s the right move for your business:

Pros of Extending Trade Credit:

• Encourages customer loyalty: When your customers know they can turn to you to source the products or services they need and have time to pay you back, they tend to appreciate it. Although some may take longer to make payments than you might like, most of them will come back again and again.
• Can lead to increased sales volume: Many customers will also spend more when they can buy with net terms. In short, the flexibility in repayment makes it easier for them to afford a larger purchase, a more expensive package, or product peripherals. For your company, this can mean higher sales.
• Gain a competitive advantage: Many companies, especially small businesses, simply don’t have enough available cash flow to offer net terms. Therefore, because customers won’t want to take out a loan just to buy products or services, the fact that you offer trade credit could make a business buy from you instead of a competitor.
• Shows your business’s financial security: Jumping off our last point, when it comes down to it, the ability to offer trade credit proves your company’s financial security. Again, this isn’t something every business can do, but if you can, it will help to establish your reputation as financially secure and responsible.

Cons of Extending Trade Credit:

• Delayed revenue: When you offer trade credit, you’ll need to accept delayed sales revenues. If you have plenty of money in the bank to cover the interim period, this may not have much impact on how you operate your business. If, however, you also operate on very thin profit margins, you may want to proceed very carefully with respect to how much trade credit you offer, and how you schedule your own payments.
• Working capital costs from late payments: If you offer net terms to your customers, you have to prepare for the inevitable fact that some will take even longer to pay. Those late payments can cause a domino effect if they push you into a negative working capital territory, forcing you to take on more financing to pay your own bills. This could be a problematic spot for your business to land in unexpectedly.
• Accounts receivable strain: When you offer trade credit to your customers, you’ll be placing significant pressure on your accounting team, who will have to keep up with the accounts receivable records, track payments, apply interest or penalties, and essentially act as a bank. The combination can put a lot of strain on your business’s finances and your operations.
• Bad debts: No matter how careful you are in vetting your customers, you will almost certainly get hit with a few who never settle their debts. There are few things more painful for a business owner than a large, eagerly anticipated payment that never gets paid. Although the IRS does allow you to write off some bad debts on your taxes if they are deemed uncollectible, it’s far better to avoid this situation as much as possible.^[1]

Best Practices for Purchasing on Trade Credit

As you can see, whether you’re looking to use trade credit or extend it to your customers, there’s a number of advantages and disadvantages to think about in order to decide if it’s the right option for your small business. This being said, if you do think trade credit may be useful for your business, there are a handful of actions you can take to ensure that you’re taking advantage of this type of business funding in the best way possible.

With this in mind, here are some best practices to follow when receiving trade credit from a vendor or supplier:

Look to smaller vendors for better terms.

Large vendors can sometimes be hesitant to extend trade credit to younger businesses or first-time customers, and those that do might include a sizable up-charge for longer payment terms. If you’re having trouble finding trade credit with terms you can afford, you’ll want to shop around for a smaller vendor with whom you can negotiate directly.

Being able to form a business-owner-to-business-owner relationship with a smaller vendor increases your chances of coming to an agreement that will meet your needs.

Don’t place orders too early.

One of the benefits of trade credit is the opportunity to greatly reduce or even eliminate the dip in cash flow between when you purchase inventory or supplies from a wholesaler and when you can make up that expense with sales revenue. Taking advantage of that opportunity, however, requires diligence to make sure that you don’t place orders earlier than necessary.

To better illustrate this issue, let’s look back at our t-shirt designing business example. Ideally, we would want to finalize the designs before we order the shirts from our vendor, place the order, and then take any necessary steps to prepare the designs for printing while the unprinted t-shirts ship. This way, when the order arrives from our vendor, we’re ready to immediately print and sell our designed t-shirts in order to pay the vendor’s invoice as quickly as possible.

When you’re relying on trade credit that comes with early payment discounts or interest-bearing terms, every day that you hold onto unused raw materials or unsold inventory is costing your business money. Therefore, you’ll want to keep an eye on your inventory management process, and look for bottlenecks that could be adjusted to reduce your trade credit costs.

Choose order quantities conservatively.

When you’re purchasing inventory or supplies on trade credit, accurately projecting your sales volume is critical. Even if your vendor offers a discounted cost for larger quantity orders, being overly eager in your sales estimates can get you into a lot of trouble, and fast.

As a rule of thumb, you’re much better off starting with a small order and selling out of a particular product for a few days than being left with a pile of sitting inventory and no way to pay your supplier. To this point, you can talk to your supplier or manufacturer about the lead time needed to turn around new orders and make a plan for how you’ll proceed if a product comes close to selling out.

And remember to let customers know when you have limited quantities of a particular product—this knowledge can help trigger a sale from your on-the-fence potential buyers.

Encourage customer pre-ordering.

A relatively common practice, when you pre-order a product, you’re actually helping pay for it—and your decision to pre-order (or not) helps the business decide how many products to create before the release.

This pre-ordering model is a great option for small consumer-driven businesses with seasonal or highly anticipated merchandise. If you have a small base of loyal customers who eagerly await the products you create, consider offering pre-orders to help you more accurately estimate sales.

You can use pre-order volumes to better anticipate the popularity of different products while using pre-order revenue to take advantage of early payment discounts from your vendors.

Keep a reserve of cash on hand.

Despite your best efforts to encourage pre-orders, accurately estimate sales, and turn inventory around quickly, it’s almost inevitable that at some point over the life of your business, your trade credit formula will go awry.

This is particularly true for B2B entrepreneurs who use trade credit with their suppliers while also extending trade credit to their customers, as one late-paying customer can quickly create a domino effect.

You’ll want to prepare for this eventuality by keeping a reserve of cash on hand large enough to cover at least one month’s supply of accounts payable—including payments on trade credit.

This requires having the diligence and the self-control to truly keep the funding untouched and reserved for a cash flow crisis, even if that means foregoing an early payment discount or some other tempting opportunity here or there.

Organize accounts payable to minimize costs.

More than anything else, the key to maximizing the benefits and minimizing the costs of your trade credit arrangements comes down to wisely managing your business’s accounts payable—that is, the method by which your business pays its bills.

In short, by streamlining your accounts payable process to pay bills in order of due date, maximize early payment discounts, and minimize late payment penalties, you can actually end up saving your business money.

Therefore, if you’ve yet to set up an organized accounts payable process for your business, you’ll want to invest in a business accounting software or work with an accountant in order to do so.

Best Practices for Extending Trade Credit to Customers

As we’ve discussed, if you operate a small B2B business, you might find yourself at both the customer and the vendor end of the B2B equation.

To this end, if you think extending trade credit to customers might be the right choice for your business, you can use these best practices to ensure you access the benefits of trade credit and minimize the associated risks:

Check your customers’ credit.

Not all B2B vendors check new customers’ credit before entering into a trade credit relationship. This being said, however, it’s a good idea to do so—especially when you’re considering a very large account.

Most of the time, late-paying customers aren’t behind on payments with just one vendor, meaning they have a well-documented history of paying late. With credit checks on other businesses available from agencies like Dun & Bradstreet for as little as $90, this upfront cost might be worth it to avoid providing trade credit to a customer who is unlikely to pay.

Track Business Credit with D&B

Set your invoicing terms clearly.

As we mentioned when discussing trade credit terms above, setting clear invoicing terms, payment guidelines, and late payment penalties is critical to making sure that your customers make their payments on time, every time. You want to make sure that customers know when payments are due, and that penalties for failure to follow those policies are enforced.

Using preset templates, your accounting or invoicing software can even help you automate payment reminders and late payment penalty notifications to help you get paid faster.

Look into invoice financing for cash flow emergencies.

No matter how cautious or diligent you may be, the near inevitability of late-paying customers in the B2B sector means that you might eventually end up with cash flow issues. Once again, a cash flow issue can quickly lead to you missing payments with your vendors, which is exactly why late payments are so common between B2B suppliers and their customers.

Therefore, if you’re at risk of a customer’s late payments becoming your cash flow emergency, you might consider invoice financing as an option to cover your immediate expenses. Invoice financing can give you immediate access to up to 85% of your invoices’ value, with the other 10%-15% held in reserve until your customers pay their invoices.

Consider trade credit insurance.

For businesses that routinely extend trade credit to relatively high-risk buyers, the cost of invoice financing can add up quickly. As an alternative, some risk managers encourage purchasing trade credit insurance to protect against unpaid orders.

Trade credit insurance is most often recommended for businesses that deal in exports to other countries, since distance, changes in the political climate, and more complex legal structures make it more likely that some customers won’t pay. If you’re primarily extending credit to local customers with whom you have an established relationship, on the other hand, trade credit insurance likely isn’t worth the expense.

The Bottom Line

At the end of the day, whether you’re looking to access trade credit from a vendor or offer it to your customers, this type of financing can work well in the right circumstances. After all, there’s a reason that trade credit is so common amongst B2B businesses.

This being said, however, before receiving or extending trade credit, it’s important to understand how to do so in the best possible way—and weigh both the advantages and disadvantages in order to come to an informed decision for your business.

Article Sources:

1. IRS.gov. “Topic No. 453: Bad Debt Deduction“