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Trade Credit: What It Is and Why You Should Pay Attention
May 11, 2009 -
Just about every survey and data source says that trade credit is the second largest source of small business financing after banks. The question is: are you taking advantage of it?Trade credit simply means that a vendor extends you credit terms, giving you extra time to pay or giving a discount for early payment.
Trade credit terms are often expressed in a kind of shorthand consisting of 3 numbers. A common trade credit term is 2/10/30.
Let’s dissect these numbers:
The first number – 2 – refers to a 2% discount. You can claim this 2% discount (deducting it from the amount owed) if you pay your vendor within 10 days – the second number. The third number – 30 – means that you must pay the balance in full within 30 days.
You will often see these 3 numbers or some variation (“2/10, Net 30”) on an invoice you receive.
Trade credit terms can vary. Sometimes the invoice might say 1/10/30 (meaning, you get a 1% discount if you pay within 10 days, and the balance must be paid in full within 30 days). Or, it might say 2/10/60 (meaning, you get a 2% discount if you pay within 10 days, and the balance must be paid in full within 60 days).
When you get an invoice with such terms on it, take advantage of them. The savings do add up.
But then you might wonder, which do I go for, the discount or the longer time period to pay?
In that case, the first thing I would look at it is my cash flow. If I were in a business where cash tended to be tight, I’d go for the 30 days to pay. That way I could keep my cash as long as possible. In essence, it amounts to your vendors providing a working line of credit for your business, at 0% interest.
If cash flow is not a big issue — let’s say you are able to keep a nice bank balance with a sufficient cash cushion at all times — then I’d grab the discount.
Let’s consider this example, of an invoice for $4,000, that you pay 12 times a year. By taking advantage of a 1% discount you save $480. If the vendor offers a 2% discount, your savings will be almost $1,000 in a year. Multiply that by several vendors, and it becomes serious money.
The way I look at it is: if I can save $1,000, I think about how much I’d need to raise prices or how many more sales I’d need, in order to drop $1,000 to my bottom line. Because that $1,000 saved is pure profit! There’s no overhead that has to be deducted from it, as would be the case if you just made an extra $1,000 in sales.
OK, that all sounds great. But what if your vendor does not offer such terms? What if the invoice merely says “Net 30,” meaning that the vendor expects you to pay within 30 days. Then in that case, there are ways to get trade credit discounts or the equivalent:
Ask the vendor for an early-payment discount. Let’s say you are able to pay for 3 months’ or 6 months’ service in advance. Vendors, especially other small businesses, will often agree readily to a 1% or 2% or even 3% discount in those circumstances, if you just ask. If you are a good customer, they will want to please you. And by enticing you to pay early, it decreases their accounts receivable cycle and improves their cash flow. So it’s in their interests to give a discount to get you to pay early.
Use a charge card that automatically gives you an early payment discount. A few years back I covered the introduction of the American Express Plum Card, which offers the equivalent of trade credit terms. It’s a neat idea: if you use the card for purchases, and pay within 10 days, you get an early payment discount on all purchases (whether your vendor offers a trade credit discount or not). And by the way, if the vendor also offers a trade discount, you can in effect get a double discount – the vendor’s discount and the discount from using the card and paying the card balance early.
Finally, let me leave you with this thought: the biggest temptation is to assume that your numbers are small and therefore these kinds of savings do not matter in your business. Wrong. The amounts might seem small individually. But, remember, savings drop 100% to the bottom line – they are all profit. When you add up small savings from a variety of sources, these are the stuff of improving your bottom line of profit.
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