How to reduce the risks associated with trade credit

Let’s get it straight. Trade credit has many benefits to the customers and sellers that issue it, but there are also many risks associated with it. It is especially suitable for the business of opening a trade letter of credit. Although companies may be inclined to adopt trade credit programs to help attract new customers and obtain larger orders, sellers (and their customers) should take steps to help reduce the risks associated with this business financing plan.

The basics of trade credit: what it is and who uses it

Trade credit Refers to a form of commercial financing that allows customers to obtain inventory and pay for purchases in the future. Trade credit is sometimes referred to as supplier credit or “net terms” and is a practice of B2B companies. When providing trade credit to customers, they agree to a payback period that usually lasts 30 to 120 days.

Trade credit may be a major attraction for some customers and can help companies sell larger orders. For customers, especially small business owners, trade credit can help them bridge the cash gap and grow their business. However, companies and customers should try to avoid providing some serious risks associated with the provision of trade credit.

When payment is too late

The biggest risk that sellers face when offering trade credit is that they may never receive payment from customers. The second is the inconvenience caused by delayed payment, and may bring devastating financial consequences. Although providing trade credit always brings some risks, a thorough review of customers can help increase the chances of working with responsible borrowers. Sellers can choose to hire a company or contractor that specializes in reviewing customer creditworthiness. Or they can handle this process internally. In the process, they may wish to obtain a recommendation letter, conduct a credit check, or process a credit application. After the application process is completed and approved, the seller needs to negotiate and publish a clear credit policy for customers to follow.

The main risk that customers face when applying for trade credit is the inability to repay the financing on time. Delays in payment may result in late fees. Default payments can lead to painful and burdensome debt collection processes. To reduce these risks, companies should only use trade credit if they are fairly certain they can make payments on time.

When payment is too early

Although it seems that late receipt of payment or no payment at all should be the main concern of the lender, receiving payment too early can also cause damage. Many trade credit programs offer early payment discounts, which may result in lower profit margins for sellers. On the other hand, customers who wish to benefit from the responsible use of trade credit should strive to take advantage of early payment discounts.

Usually, the early payment discount is an incentive offered by sellers to attract customers, but doing so means losing some profits. Even if the early payment discounts are small, they can add up if multiple customers take advantage of these discounts. Not to mention, discounts may cause logistical confusion in your accounting process. They can also complicate financial forecasting because you cannot be sure what the final profit will be. If the seller provides personalized early payment incentives for each customer, it may further increase internal chaos. If possible, sellers should consider avoiding early payment discounts.

When the company’s growth may stagnate

Trade credit can give both parties a good impetus, but it can also easily hinder the seller’s business growth. Providing customers with inventory before accepting payment may result in cash flow risks. The best scenario is that the customer repays the debt at the end of the loan period, but during this period, the seller’s company is in debt to cover the costs of supplies, employees, and suppliers that they must pay. If customers don’t pay on time, sellers may find it difficult to pay their bills. In this case, having an alternate source of funding (such as a credit card or commercial line of credit) can give you peace of mind and provide emergency funds.

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