Small businesses generally use accounts payable as their largest source of financing. Accounts payable, or trade credit, are what businesses owe to their suppliers of inventory, products, and other types of goods that are necessary to operate the business. It is estimated by most experts that small businesses usually have as much as 40 percent of their financing from trade credit - what they owe their suppliers.
It is certainly the single largest operating current liability on a small business' balance sheet. The smaller the firm, the higher the percentage of trade credit as a current liability.
How Does Trade Credit Work?
When a company buys from a supplier, that supplier is often willing to allow the company to delay payment. When the supplier allows delayed payment, effectively the supplier is extending financing to the company. This credit becomes a source of working capital financing for the company. For very small businesses and start-up companies, trade credit may literally be the only financing they have. Suppliers know this and they keep an eye on their accounts receivable and the companies that hold credit with them.
Pick Your Suppliers Carefully
When your business doors open, one of your first tasks should be to pick your suppliers carefully. You want to pick your suppliers not only for the products they can offer you but also for their terms of trade credit. If you are a new or growing business, you certainly want to pick suppliers that do offer trade credit and preferably those that offer generous terms of trade credit.
When you are choosing suppliers, you will generally make a presentation or proposal to those suppliers. Be sure and emphasize how much inventory you will need and how much inventory you anticipate needing going forward into the future. You want to make your company look attractive to the supplier as a company worthy of trade credit. The more business you do with a supplier, the better your negotiating position will be with regard to the terms of trade credit with that supplier.
The Cost of Trade Credit
There is a cost associated with having trade credit granted to your company by your suppliers. Suppliers are probably in the same position you are regarding cash flow, so the purchase price of what you purchase from the suppliers is often higher than if you were paying cash. Not only do you have to absorb the higher purchase price, but you have to figure in the actual cost of trade credit.
Firms that offer your company trade credit have a credit policy, just as you have a credit policy for your customers. That credit policy may have terms of trade that look something like this: 2/10, net 30. This means that the supplier will offer you a 2 percent discount if you pay your bill in 10 days. If you don't take that discount, then the bill is due in 30 days. If you are offered these terms of trade by a supplier, what do they mean?
Here we can use a formula to calculate the cost of trade credit. This formula is also called the cost of not taking the discount. Let's say that your company is offered terms of trade of 2/10, net 30. We figured out what that meant in the previous section. Now, we have to imagine a scenario where your company is not able to take that 2 percent discount. In other words, you do not have the cash flow to pay the bill and receive the discount within 10 days. What is this going to cost you?
Here is the formula to calculate the cost of not taking the discount:
Discount Percent/100 - Discount percent X 365/Days Credit is outstanding - Discount period = Cost of Not Taking the Discount
Using our example:
2/100 -2 X 365/30 - 10 = 37.2%
37.2% is the cost of not taking the discount to your company. You could get a bank loan for much cheaper than that. This formula actually understates the cost of not taking the discount because it does not consider time value of money.
Should Your Company use Trade Credit
Should your company use trade credit to buy its inventory and supplies or another source of financing? If your company has the free cash flow to take the discount offered in the terms of credit, then yes. However, you should calculate the cost of trade credit, or the cost of not taking the discount, as we did in the section above. If you do not have the cash flow to take the discount, you are usually better off with a cheaper form of financing. It is always better to have enough cash flow on hand to take the discount.