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In an ideal world, trade credit probably wouldn’t exist. Businesses would always have enough money in the bank to buy raw materials, supplies, and inventory. Merchants wouldn’t have to wait to get paid on net terms. Everyone would settle their accounts immediately and move on.
Things don’t quite work that way, though. For many businesses, cash is a luxury. In fact, according to CB Insights, 29% of new businesses fail because of “lack of sufficient capital.”
Because so many small businesses operate with such thin margins, they often don’t have the money on hand to buy the inventory or raw materials necessary to fulfill large orders. This forces them to rely on short-term financing options, so that they can get what they need quickly. Trade credit, also known as net terms or vendor credit, is a financing option common among business that serve other businesses.
If you run a B2B company, you may be wondering if you should offer trade credit, and if so, how much. This is a decision that can have a major impact on your bottom line.
Here are four factors to consider when making the choice to offer trade credit.
The cost of goods sold (COGS) refers to the value of all the direct costs involved in what you’re selling. That can include the raw materials used to make your products, the labor costs involved in producing them, and any manufacturing overhead that is directly tied to the product.
When you offer trade credit to your business customers, you are going to have an impact on the total COGS for those products. One reason for this is that every day you aren’t getting paid, you’re sacrificing interest income that you could be earning, if you already had the money in your bank account.
When you offer trade credit, you’re offering to let your buyer have their order now, and pay for it later. That means 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 margins, you may want to proceed very carefully with respect to how much trade credit you offer, and how you schedule your own payments.
One way to avoid this issue is to use a service like Fundbox Pay, which acts as an intermediary in the trade credit process. Merchants offering Fundbox Pay as an option for their customers can get paid right when they make a sale, while allowing approved customers to take advantage of the net-60 payment terms they need, for free. Services like these are becoming increasingly popular with merchants looking to eliminate payment delays.
If you offer net terms to your customers, you have to prepare for the inevitable fact that some will take even longer to pay. Let’s say you offer 60-day net terms to one of your customers. Even if you remind them nicely, or charge them late fees, you can’t be sure they will actually pay their invoice within 60 days. After all, 64% of small businesses are affected by late payments.
Those late payments can cause a domino effect if they push you into negative working capital territory, forcing you to take on more financing to pay your own bills. That’s an uncomfortable spot to land in unexpectedly. When deciding whether to offer trade credit, make sure to account for late payments, and only extend as much credit as you can comfortably float without threatening the stability of your own business.
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.
While 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. You can protect yourself by thoroughly screening your customers before allowing them to participate in a trade credit program, requiring references from customers who are seeking longer credit terms, and only offering credit to customers you truly trust.
When deciding whether to offer credit to the businesses you transact with regularly, these are four of most important the factors you’ll want to consider. The decision may ultimately come down to how things are typically done in your industry. After all, over half of B2B businesses offer some kind of credit to their business customers. Offering credit can help your customers increase their buying power, as well as keep them loyal to doing business with you.