Trade credit is where suppliers give you working capital like inventory or materials now and let you pay for them later based on terms you negotiate. This frees up cash flow for other needs like payroll or rent, and lets you wait for future sales to pay your vendors.
Trade credit allows you to stock up for the busy season and use cash on hand to hire additional workers or fill shelves for a new location before the doors open. It also improves your business credit score by building the history of on-time payments.
Here are the steps for using trade credit to pay for working capital along with the pros, cons, and how you can combine it with other financing options in your business.
Steps to Use Trade Credit for Working Capital
There are 5 steps to use trade credit for working capital.
- Negotiate terms with suppliers.
- Forecast cash flow requirements.
- Place orders.
- Track sales progress.
- Monitor your business credit score.
Not all suppliers or vendors will offer it, and you’ll negotiate terms with each supplier based on your relationship with them and their ability to extend credit. If none of your current suppliers offer trade credit, but it is something you want, shop around a bit.
There’s no harm in seeing if there’s another reliable vendor which may help you if you’re looking to expand your business or grow your product lines with this strategy.
Negotiate terms with suppliers
Start by asking suppliers if they are willing to offer and negotiate trade credit. Longer terms like net-90 let you hold onto cash or give more time for sales to come in, although some vendors might only offer net-30 or net-60.
Negotiating early payment discounts provides flexibility to save money when sales roll in faster than expected or you have extra cash on hand from lower expenses. In exchange, your supplier will likely want a late payment penalty to compensate them for the risk of giving the trade credit and waiting for payment.
Forecast cash flow requirements
Forecasting cash flow requirements makes sure you can pay the trade credit on time to avoid damaging supplier relationships or hurting your credit score.
Create a spreadsheet like the table below that shows the incoming cash flow from future sales versus outgoing cash expenses like payroll, rent, and utilities for each of the next few months. This shows how cash flows into and out of the business to ensure cash on hand is always positive to build confidence that the suppliers will get paid.
| Month | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Revenue (Total Cash In) | $40,000 | $50,000 | $70,000 | $70,000 | $70,000 | ||
| Trade Credit Received | $50,000 | $25,000 | |||||
| Trade Credit Due | $50,000 | $25,000 | |||||
| Payroll | $10,000 | $10,000 | $10,000 | $10,000 | $10,000 | $10,000 | |
| Rent | $2,000 | $2,000 | $2,000 | $2,000 | $2,000 | $2,000 | |
| Utilities | $500 | $500 | $500 | $500 | $500 | $500 | |
| Other Cash Expenses | $3,000 | $3,000 | $3,000 | $3,000 | $3,000 | $3,000 | |
| Total Cash Out | $15,500 | $15,500 | $15,500 | $15,500 | $15,500 | $15,500 | |
| Cash on Hand | $20,000 | $4,500 | $29,000 | $63,500 | $118,000 | $172,500 | $227,000 |
Place orders
Check with each supplier whether they have different processes to place orders with trade credit versus using cash. It’s also a good idea to check with their finance department when making your first order to ensure they are tracking the terms you negotiated in step 1 so there’s no mix-up when it comes time to pay.
Track sales progress
Track sales closely and compare actual sales versus the forecast from step #2 to make sure you’re on track or ahead of schedule. That way you can fix things before they become problems if sales aren’t coming in as expected by working out extended terms with suppliers, seeking a small business loan to cover the gap, or cutting costs from other parts of the business.
Monitor your business credit score
Check with the business credit bureaus Dun & Bradstreet, Experian, and Equifax to make sure your supplier reported your trade credit and payments so your score grows and helps you get better terms from both suppliers and small businesses lenders in the future.
Follow each bureau’s instructions to report any errors as soon as possible to avoid a drop in your credit and tell your supplier to also contact the bureau and confirm they made a reporting error.
Repeat this 5-step process to use trade credit for working capital with each of your vendors, and if some vendors are unable or unwilling to offer it, then you can use some of the other financing options below.
Pros and Cons of Using Trade Credit to Pay for Working Capital
The pros of trade credit, like access to capital without needing cash and cost savings versus using standard business loans, outweigh the cons of its narrow use and possible risks if sales don’t live up to expectations.
Pros:
- Frees up cash flow: You pay for inventory or materials later and can use cash on hand to fund other business needs like payroll, rent, or advertising.
- Access to working capital when cash is low: New businesses without much cash on hand get access to working capital needed for sales to establish their business. Existing businesses benefit by stocking shelves in new locations when limited cash flow can’t cover all the pre-opening costs.
- Builds relationships with suppliers: Making regular payments builds trust, gives them consistent cash flow to grow their business, and leads to better negotiated terms in the future.
- Lets you avoid additional costs from debt: There’s no interest or fees with trade credit as long as you don’t have a late payment penalty. Contact your vendors the moment you know a payment might be late and try to negotiate an extension. If that’s not possible, ask if they’ll make an exception and not report the late payment to the credit bureaus so it doesn’t hurt your score.
Cons:
- Can strain supplier relationships: Missed or late payments add risk to your vendor’s business and strain the relationship where they might cancel the trade credit and hurt your business’s credit score.
- Cash flow risks: If your vendor goes out of business or runs out of inventory, you will have to come up with cash for working capital from someone else where you might not have time to set up the trade credit.
- Limited use: Trade credit only works for the working capital your suppliers provide, and you’ll need cash or other financing for things they don’t sell.
Using Trade Credit with Other Working Capital Financing Options
Using trade credit together with lines of credit, working capital loans, and invoice factoring (where you sell invoices for a discount to a third party) helps manage working capital needs through any changes in the business.
Getting approved for a line of credit lets you access funds for working capital when needed without waiting through another approval process. This way you’ll have immediate access to cash to avoid late payment penalties when your own customers are late, and you need to pay suppliers’ trade credit. It also helps if things like weather push sales out to future weeks.
Lines of credit will also pay for working capital that trade credit doesn’t whether it’s a product from a new supplier or extra inventory you need above your credit limit.
Working capital loans are short-term loans with fast approval that you can use for extra inventory above your trade credit limit or for things suppliers don’t offer. They can work together with a line of credit and trade credit when you need lots of cash flow.
Invoice factoring can add to profit margins when the factoring discount is less than any early payment discount you’ve negotiated with trade credit. Imagine you owe a supplier $1,000 for inventory you have sold to different customers for a total of $2,000.
| Invoice Factoring | Trade Credit | |
| Invoice Factoring Discount / Early Payment Discount | 2% | 3% |
| Invoice Amount | $1,000 | $1,000 |
| Cash Received | $980 | NA |
| Cash Paid | NA | $970 |
You keep an extra $10 in profit by factoring half your invoices and paying your supplier early.
Following the steps above to pay for working capital with trade credit and combining that with other financing options lets you manage through any business situation or surprise while building strong relationships along with your business credit score.
