Due to the economic downturn and the tightening of the credit markets, the way that credit is supplied and acquired is changing. With the decrease in available debt capital, new approaches to financing have emerged. One method for companies to establish corporate credit is through trade credit.
Importance of Trade Credit
Trade credit terms that give customers a grace period before cash payment is due, is a necessary form of credit that allow companies to maximize cash flows. Credit terms like NET 30, provides purchaser what is in effect a thirty day no interest loan to purchase inventories and other supplies. With beneficial vendor terms cash flow are maximized, since increased inventory levels and operating resources can support a greater level of sales than can be accomplished when making cash purchases.
Providing credit terms to customers also benefit vendors by allowing customers to purchase more on credit than they otherwise could with cash. In the current economic environment, vendors can take the place of traditional financing institutions by extending credit terms. For example, by extending payment terms from NET 30 to say NET 60 a customer can continue to operate and earn enough money to pay for inventory at the end of the 60 days, which allows the vendor to continue a business relationship that might have otherwise disappeared.
Negotiating trade agreements is also a cost effective method of financing. With the exception of retained earnings, obtaining credit from other businesses is the cheapest form of business financing. In the current economic environment, the availability and lower cost of capital in relation to other forms of financing can make trade credit a more effective financing alternative than short-term bank loans and credit lines.
Establishing Corporate Credit
Trade credit also provides businesses an opportunity to establish corporate credit. Most business credit scores and other credit ratings in some way factor the timing of a business’ payments to its suppliers and creditors within the agreed upon terms of payment. For example, Dun and Bradstreet’s PAYDEX Score, which is a unique numerical indicator that represents how a firm paid its bills over the past year, based on trade experiences reported to D&B by various vendors. In order to establish corporate credit a company not only needs to manage its business relationships with vendors, but must also pay its credit invoices within the period prescribed by any predetermined credit terms.
Trade credit can be provided in several different forms including: extended payment terms, quantity discounts, equipment loans, and consignment sales. The following are steps that should be considered when applying for any type of trade credit that can also help establish corporate credit:
Make a formal application for credit:
Every business that extends trade credit should require that their formal application, including the applicant business’ formal name, ownership, and information on banking relationships and other credit providers, is completed. In the current economy, the cost of not providing the necessary information or having established corporate credit in advance is the possibility of the application being denied, having to provide personal guarantees, or having to pay COD for inventory that would have otherwise been billed on credit.
Manage bank and trade references:
The purpose of establishing a corporate credit profile is so you can orchestrate what vendors will see when deciding on how much credit to extend to the business. : If the sponsoring company asks for your bank and trade references it means that they are planning to contact them. Not discussing your credit needs and goals with your references, or waiting until the last minute to discuss their testimonials, is a recipe for rejection
Check credit bureaus and other credit metrics:
Business relationships with the credit bureaus should be instituted well in advance of the need for sizable amounts of trade credit. Any errors in the bureaus’ credit reports must be fixed and any seemingly negative information should be addressed and explained in your credit profile or included in the credit application.
Set expectations with creditors:
Being specific about the need and use of capital will assist vendors in assessing their credit risk and help in obtaining preferred trade terms. Actual performance should be tracked against expectations and communicated with vendors. The ability to achieve what the business set out to accomplish, will increase business credibility and help enhance trade credit.
Due to changes in the credit markets businesses to rely on each other and less on financial institutions for financing. Businesses are willing to finance customers because doing so helps to expand overall market demand. However, these changes are also requiring small business owners to build the necessary business relationships and establish corporate credit far in advance of the need for capital.