What is trade credit? How does it work?

Trade credit is similar to a high-street sofa store selling furniture on a 'buy now, pay later with zero interest' promotion.

Yet instead of consumer goods, trade credit is typically offered to businesses buying materials, equipment and even services without having to pay upfront.

Understanding how trade credit works can help your business decide if it needs it.

What does trade credit mean?

Many businesses, especially in building and construction trades such as carpentry, decorating and roofing, rely on trade credit.

Trade credit is the credit extended to small businesses by suppliers that effectively allows them to buy materials and goods now and pay for them later.

Trade credit works as a form of short-term, unsecured debt where the supplier is loaning the equipment of goods to the business and expects payment by an agreed deadline.

Unlike a loan from a bank, trade credit is usually interest free - which means a business only needs to pay back the amount equal to the value of the goods they purchased without any additional fees.

Why use trade credit?

Trade credit is useful to small businesses and startups looking to build a customer base and establish a good relationship with suppliers, and it can help establish business credit.

Trade credit also frees up cash that could be spent on other, more pressing capital expenditure needs.

Buying materials at the start of a project can be a challenge for smaller businesses, especially in building or home renovation trades.

Small firms face a dilemma: ask the customer to pay for materials up front or potentially have to turn down a job due to lack of funds.

Small businesses face the additional risk of buying materials and the customer either cancelling the project or not paying - leaving the business struggling with cash flow and holding materials that are no longer needed.

Trade credit can alleviate this. By using trade credit, the cost to the small firm buying materials is essentially zero at the start of a project.

By the time the trade credit payment is due to the supplier, the customer should have made a payment that will cover the cost of the materials.

Trade credit can also be a lifeline in the early stages of a startup. Many small businesses can't easily obtain credit or loans when starting out and need to reply on trade credit to operate.

If your business is unable to secure funding through a short-term loan from a bank, trade credit can ensure materials and equipment can still be purchased.

Why offer trade credit?

Trade credit is useful for suppliers, too. If you're a small business supplying other companies with materials, such as a builders' merchant, offering favourable trade credit terms can be attractive to smaller businesses.

Offering trade credit can give you a competitive edge over rival businesses that insist on payment upfront.

Suppliers that offer trade credit often attract larger contracts and more business - but there are risks.

Businesses that take supplies from you using trade credit can default, and it can prove difficult to recover the money, especially if the business has ceased trading.

A prime example was the collapse of the construction giant Carillion in 2018. It collapsed owing suppliers over £30m, with sums ranging from thousands to several million pounds.

According to Creditsafe's Watchdog Report bad debt owed to UK companies has rocketed in recent years, rising over 367% in the first quarter of 2018.

How trade credit works

Trade credit is useful for small business owners who need inventory but lack the cash in hand to make the purchase upfront.

It is usually arranged by negotiating terms with a supplier, though many larger suppliers will have an established trade credit system in place.

Trade credit is usually offered for a specific term. Depending on the type of business, terms can range from seven days to three months, though goldsmiths may offer terms of 120 days or more. The most common repayment term, however, is 30 days.

Unlike a loan from a high street bank or business lender, the terms surrounding trade credit are less formal. Usually there isn't a wealth of terms and conditions, and many terms are agreed verbally.

However, take time to read the small print when signing up to trade credit. There are often penalties for late payment and interest can be levied on any outstanding amounts owed after the payment term.

Trade credit definition - example:

A digital printing company has an order to design and print 100,000 brochures for a national business.

Rather than pay upfront or obtain a short-term loan to buy the paper, it arranges with the paper supplier to obtain enough paper on trade credit to design, print and deliver the brochures.

The trade credit terms are 30 days, and the entire project is delivered in 15 days with the customer paying on delivery - giving revenue to the printer and ensuring the trade credit amount can be paid back within the agreed terms.

Getting trade credit

While trade credit is most beneficial to small businesses, it's often start-ups that struggle to get favourable trade credit terms until they can prove they can consistently pay their bills on time.

If you're just starting out, you'll need to pay upfront or cash on delivery until you can establish a payment history.

However, by building a good relationship with your supplier you can move quickly from cash on delivery to a trade credit agreement:

Build a payment history - If money is tight consider purchasing smaller, regular supplies to show you're a loyal customer. Make sure you pay upfront and that payments clear without problem.

Provide references - Suppliers will want to know if your business is reliable when you request trade credit. Provide two or three trade references and ask them you to vouch that you can pay on time.

Ideally you should have a trade credit account with the references so they can confirm how long you have been using trade credit and that you always meet payment deadlines.

Improve your credit rating - To reduce their credit risk, suppliers often use credit rating agencies to determine how much credit to extend to customers.

Suppliers get your credit rating from credit agencies, which use many sources of information to give a business a credit score.

Your credit rating is based on various things such as your payment history with other firms. If your business is a limited company, credit agencies will look at your accounts filed at Companies House.

One tip to help boost your credit rating is to file business accounts early - late filings may be viewed adversely by credit agencies who will then downgrade the credit score.

Filing full rather than abbreviated accounts can also work in your favour, too.

Negotiating credit terms

When applying for trade credit, make sure you're clear on the terms and conditions that are part of any agreement.

These are usually included on your invoice, along with payment deadlines and the amount of interest charged if you miss the deadline.

Suppliers generally consider several things when deciding to grant trade credit to a business:

Trading history - How long your business has been trading has an impact on the credit terms you can negotiate.

Long-established businesses with good credit history and a strong financial record will score more favourable trade credit terms compared to new businesses that do not have a proven credit trading history.

Risk - The risk is with the supplier when they release goods or materials to you. If your business ultimately fails to pay, the supplier faces a financial hit. Your ability to pay is a key consideration of trade credit.

If your business is relatively unproven, expect shorter repayment deadlines and lower credit amounts available to your business.

Types of goods - Different types of goods have different trade credit terms, driven by their shelf life.

Construction materials or precious metals have a long shelf life and can be easily repurposed into other projects, attracting longer repayment deadlines.

Perishable goods, such as produce, need to be sold on quickly so have far shorter deadlines for paying the supplier.

Remember that a trade credit agreement is effectively a contract. It's worth getting legal advice if you're not sure of the trade credit definition terms used within an agreement.

You need to be fully aware of the obligations the agreement places your business under, and any requirements on your part.

When agreeing terms, ask for an early repayment clause. This can provide a benefit, such as a discount or an extension of future deadlines, if you repay the trade credit amount early.

Credit insurance

If your business supplies other companies and offers trade credit, it may be worth considering trade credit insurance. This protects suppliers from bad debt, where firms take on trade credit but are unable to pay.

Trade credit insurance gives an additional layer of security, allowing suppliers to offer trade credit safe in the knowledge that if a customer defaults on payment they won't lose out.

There are lots of different types of trade credit insurance policy; speak to a specialist business insurer to help choose the right one for your business.