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Ask About Trade Credit

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By | May 26, 2012

Dear Toolkit,

I'm a soon-to-be entrepreneur with more enthusiasm than business knowledge. Can you explain what "trade credit" is and how I might be able to use it as I begin my new business?


Rookie in Roanoke

Dear Rookie,

Welcome to the world of entrepreneurship, where your suppliers often represent a possible source of financing through a variety of credit and pricing options.

"Trade credit" is the generic term for a buyer's purchase of goods from a seller (supplier) who finances the purchase by delaying the date at which the price is due, or by allowing installment payments.

Suppliers are often willing to sell on credit, and this source of working capital financing is very common for both start-up and growing businesses. Vendors know that most small businesses rely primarily upon a limited number of suppliers and that small businesses typically represent relatively small order risks. As long as the supplier keeps a tight rein on credit terms and receivables, most small businesses are a worthwhile gamble for future business.

Startup businesses may benefit from shopping for prospective suppliers as soon as the entrepreneur has a business plan and a location picked out. Many new businesses rely heavily upon a single supplier with whom they can reach a long-term understanding regarding credit purchases.

Present your proposal to several possible suppliers, taking care to outline how much inventory you need to get started and how much you will buy from the supplier in the future. Expect the supplier to demand a priority security interest in all goods provided to you on credit. You may also have to personally guarantee some of the purchase price, at least for initial inventory. The more business you do with a particular seller, the better your negotiating position for arranging additional credit purchases.

When managing the amount of trade credit and other debt your business assumes, the critical feature is not the total amount of debt, but rather the ability of your business to make payments from its cash flow. The duration of the pay period and the repayment amounts, in relation to incoming cash sources, are most important. Realistic cash flow projections and a strong cash flow history are consequently the primary interest of trade creditors.

The major advantages of trade credit are that it is often readily available; it allows you to spread your payments over several months or years; and minimal, or no, down payment or interest charges are assessed.

Trade credit may be in the form of a simple delay in payment for purchases, sales on consignment, equipment loans, or a variety of different options to assist dealers in financing stock purchases. For instance, a supplier might agree to a promotion plan that allows you to pay for specific items only as they are sold (supplier retains ownership of goods until paid for). This plan permits the supplier to continually monitor the mix of merchandise on your shelves and to adjust to changes in demand.

Buying on consignment is also an inventory financing option in some industries, such as retail print products, electronic consumer products, or furniture. A purchase on consignment means that you pay the supplier for goods only if, and when, they are sold. The supplier keeps title to the goods and when they are sold, you retain a portion of the sale and return the balance to the supplier. There are no significant upfront costs and if you don't sell it, you simply return it to the supplier.

The cost of trade credit is usually a higher purchase price. Keep in mind that vendors often experience the same cash flow pressures as small businesses and many sellers offer cash discounts for immediate payment. By purchasing on credit, you forego the cash discount price and pay a higher relative price for your goods. But, hey, you knew there was no such thing as a free lunch, right?

So make good use of your trade credit opportunities and hang on to your enthusiasm, for both will help get your new business off to a running start.

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