Trade Credit: How to determine if you should offer net-30 terms
to your business customers
What is trade credit?
One of the major differences between consumer and commercial
transactions is that most, if not all, consumer transactions are
paid in cash or by credit card at the time of sale. Because of
this, most consumer businesses never have to worry about
extending credit to a customer and can run their operations on
an "all cash" basis. This allows them to focus on their core
competencies because they don't have to carry slow paying
Accounts Receivables and go through the expense of collecting on
such accounts.
However, commercial transactions are different. Most clients ask
their suppliers to deliver services immediately and then to
invoice them for the work, payable 30 days later (also known as
offering net-30). In effect, clients ask their suppliers provide
them with "trade credit" for 30 days. Although suppliers don't
like offering trade credit, most have accepted it as an industry
standard and have learned how to operate and live with it. In
fact, some suppliers have even mastered how to offer trade
credit and use it to better position their companies with
leading clients. Large creditworthy customers, such as the
government or large companies, will usually demand trade credit
as part of their contract negotiations. Some examples of
entities that ask for 30 to 60 day payment terms are:
o Fortune 500 companies
o Large and medium sized companies
o State government agencies
o Federal government agencies
On the positive side, providing trade credit to the proper
clients can be a tool that allows your company to win important
contracts and position it for growth. However, providing credit
is also risky and can erode the company's cash position if it is
misused. Furthermore, offering trade credit to
less-than-creditworthy clients can burden the company with bad
debt and affect its growth prospects. Because of this, business
owners must walk a fine line balancing their desires to grow
their businesses with the necessities of offering credit to
their customers.
Keys to providing trade credit successfully
The best way to minimize the risk of providing trade credit to a
client is to perform a credit analysis on him. Although no
credit analysis is 100% perfect, they allow business owners to
make an informed decision on whom to issue credit to. Here are
the three key points to making a credit analysis.
o Have the customer fill out a credit application
Have all your customers that want credit fill out a simple
credit application. This will allow you to have all relevant
facts in a single document. The application should ask for the
following information: 1. Company structure 2. Banking
relationships 3. Commercial references 4. Supplier references
o Check bank and supplier references
In their credit applications most clients will only list banking
and commercial relationships that will position them in a
favorable light - however - it is always a good idea to check on
all of them anyway. Banks will only be able to confirm that the
client has an account with them. Supplier references, however,
may provide critical information regarding the clients' payment
habits.
o Check commercial credit reports
There are a number of companies that sell commercial credit
reports on businesses. As opposed to consumer credit reports
that require special permissions, commercial credit reports can
be obtained for any business without asking for prior
permission. Reports vary in their level of detail and accuracy
and can be obtained for as little as a few dollars. However, all
reports will include important information to help your credit
department make a decision. More detailed reports will cost a
few hundred dollars. You can obtain credit reports from the
following companies: a) Dun & Bradstreet (www.dnb.com) b)
Experian (www.experian.com) c) Credit.net (www.credit.net)
Doing a credit analysis on your clients will allow you to
determine how much - if any - trade credit you can give them.
Clients that do not have a favorable credit analysis should be
placed on a COD (Cash On Delivery) basis, at least initially, to
reduce the risk of non-payments.
The challenges of offering trade credit
One of the main drawbacks of providing trade credit is that it
can create a cash flow problem for the company that offers it.
Large suppliers with adequate cash cushions in the bank can
easily afford to offer credit. However, small suppliers with
lean bank accounts usually find that offering credit will drain
their cash resources and create financial challenges. It is not
uncommon for small businesses to find themselves with a cash
flow gap after offering trade credit to their larger clients.
This gap is created by the fact that the company's Accounts
Receivable account is strong while the company's bank accounts
and cash position are weak. The cash flow gap places the
business at risk of missing payroll and debt payments. It also
prevents it from pursuing new opportunities because they don't
have the funds to buy resources or hire the necessary staff.
Bridging the "cash flow" gap
The biggest asset that most new businesses have, aside from
their equipment and intangibles (e.g. employees), is their
unpaid invoices or Accounts Receivable. Accounts Receivable is
an asset that can be quickly converted into cash by using a
financial tool called factoring. Factoring allows a business
to sell the financial rights to their Accounts Receivable to a
third party, called a Factor. As part of the sale, the factor
immediately advances a large portion of the cash value of the
unpaid invoices to the business. The business can then use this
cash infusion to strengthen its cash position and meet its
obligations. In the meantime, the factor, which now owns the
invoices, waits to get paid by the customer. Factoring enables
business owners to outsource their trade credit function to the
factor and to turn their companies into the equivalent of an
"all cash" business. If you want to learn more about factoring
and how it can be used to grow your business, please read our
white paper titled "Factoring: Cash on Demand for your business
without debt or loans"