Small businesses generally use trade credit, or accounts payable, as a source of financing. Trade credit is the amount businesses owe to their suppliers on inventory, products, and other goods necessary for business operation. Trade credit can often be the single largest operating liability on a small business' balance sheet.
How Trade Credit Works
When a trustworthy company buys from a supplier, that supplier will often allow the company to delay payment. When the supplier allows delayed payment, they are effectively extending financing to the company they trust, and this credit becomes a source of working capital for the company to spend elsewhere. For small businesses and startups, trade credit may be the only financing available to the company; thus, suppliers know to keep a close eye on their accounts receivable, and on the companies that hold credit with them.
Pick Suppliers Carefully
When opening a business, you must pick suppliers not just for the physical products they can offer, but also for their performance record and their terms of trade credit. If you've opened a new business, you should aim to work with suppliers that offer room to grow into more favorable trade credit terms, achievable through consistency and trust-building efforts on your part.
When choosing suppliers, new clients will generally submit a proposal emphasizing how much inventory their business will currently need, as well as projections for how much they anticipate needing in the future. You should find evidence to demonstrate how your company is well suited to the supplier and a company worthy of trust and trade credit. The more business you do with a supplier, the better your negotiating position will be with regard to the terms of trade credit.
The Cost of Trade Credit
There are costs associated with having trade credit granted to your company by suppliers. Suppliers are generally in the same position you are regarding cash flow, so the effective cost of what you purchase from the suppliers is often higher than if you were paying cash. Not only do you have to absorb the higher purchase price, but you have to figure in the actual cost of trade credit.
Suppliers likely have a credit policy for their trusted customers. That credit policy may have terms of trade that look something like this: 2/10, net 30. This means that the supplier will offer you a 2% discount if you pay your bill in 10 days. If you don't take the discount, then the bill is due in 30 days. If you're offered these terms of trade by a supplier, what do they mean?
Calculating Cost of Trade
Below is a formula for calculating the cost of trade credit. You can also use this formula for calculating the cost if you don't take the trade discount. Let's say your company is offered terms of trade of 2/10, net 30 but is not able to take the 2% discount. In other words, you don't have the cash flow to pay the bill and receive the discount within 10 days, what is this going to cost you?
Here's the formula to calculate the cost of not taking the discount:
Discount Percentage ÷ (1-Discount %) x [360/(Full allowed payment days - Discount days)]
Here's the step-by-step explanation of the formula using the example given above: 2/10 net 30.
- Divide the discount percentage, 2%, by (100% - 2%), the difference of 100% minus the 2% discount percentage. It equals 2.0408%
- Divide 360, nominal days in a year, by the sum of full allowed payment days (30 days) minus allowed discount days (10 days). It equals 18.
- Multiply the result of 2.0408% by 18. It equals 36.73%, the real annual interest rate charged.
According to the terms in our example above, 36.73% is the cost of not taking the discount. You could get a credit union or bank loan at a lower rate than that.
Using Trade Credit
Should your company use trade credit to buy its inventory and supplies or another source of financing? If your company has the free cash flow to take the discount offered in the terms of credit, then yes. However, you should calculate the cost of trade credit, or the cost of not taking the discount, as in the section above.
If you don't have the cash flow to take the discount, you're usually better off with a cheaper form of financing. It's always better to have enough cash flow on hand to take the discount.