External sources of finance come from outside the business. Trade credit belongs to external sources of finance. When businesses need to use the money for a short period of time (less than one year), this creates the need for short-term finance.
3. Trade credit
Individual customers pay in cash for goods and services which they purchase, But, businesses buy most of their resources on credit. The business buys now and pays later.
The sale is made by the seller at the time of purchase. However, the seller does not receive the cash from the buyer immediately, but at the later date.
In this way, the seller provides trade credit to the buyer when purchasing raw materials, components or finished goods. In fact, the supplier is lending the money for the cost of products for the length of the agreed trade credit period, usually between 30 and 180 days.
How does trade credit work?
Businesses use trade credit to delay payments to their suppliers. They negotiate payments terms with their suppliers in order to take longer to pay outstanding invoices.
When a business can purchase USD$10,000 worth of raw materials (e.g. chickens, vegetables and bread to produce hamburgers) and pay within 90 days, it means that the business has that USD$10,000 available for three more months. By delaying the payment for goods or services received, the business is ultimately obtaining finance. This is considered as a short-term source of finance because trade credits usually never go longer than 365 days.
The money can be used to pay other Short-Term Liabilities such as pay back the overdraft, settle wages for production workers or pay utility bills. The longer the trade credit, the more liquidity the firm has.
Benefits of trade credit
- Allows to buy supplies now and pay later. Trade credit allows a business to purchase supplies from the supplier, and pay until a later date. Suppliers that offer trade credit usually allow 30 days, 60 days or 90 days for their customers to pay. Those suppliers, or Creditors on the Balance Sheet, who are providing products without receiving immediate payments, are actually ‘lending money’ to the business for a few months.
- No need for collateral. The Creditor does not take out any collateral, or a guarantee, on the trade credit given. Because the debt is unsecured, the supplier has no rights to the business’s property, if the business defaults on paying the trade credit in the end.
Drawbacks of trade credit
- No discounts for immediate payments. Trade credit is not free. Any discounts offered by suppliers for immediate payments are given up. These cash discounts are usually around 1%-2% of the total amount on the invoice. Although, some suppliers may offer up to a 5% discount.
- Damaged relationship with suppliers. If the business takes too long to pay its suppliers, confidence might be lost resulting in worsened relationship. In the future, the supplier may always demand cash payment before delivery.
- Supplies might be stopped. If delayed payment occurs too often, the supplier may refuse further deliveries until all outstanding payments are made.
Overall, it is always better for the business to keep cash for as long as possible and delay payments to suppliers. In this way, the business may improve its short-term finance. So, trade credit comes in handy.
