The Cost of Trade Credit
Most trade credit agreements are not interest-bearing in the traditional sense, but that does not mean that purchasing goods or services on trade credit comes without cost. If you pay attention to your vendor’s invoice terms, you will find the saying holds true that “there's no such thing as a free lunch.”
Let's take a look at the two most common methods that vendors use to protect their cash flow when extending trade credit to business’. From your perspective as a potential business, these are costs of doing business on trade credit—not unlike the cost of interest on a loan.
Cash or Prompt Payment Discounts
To improve cash flow and shore up their own cash on hand, vendors that routinely issue net 30 or net 45 invoices on trade credit sometimes include in their terms a percentage discount for cash on delivery or prompt payment of invoices. This could include terms such as a 5% discount on invoices paid within 10 days of issue, for example.
It sounds like a dream scenario, right?
Your vendor is willing not only to extend trade credit on the order you placed but is even discounting your order if you can pay earlier than requested! But let’s stop and think about this for a minute, because the term discount in this context is a bit deceiving.
Remember, the vendor is the one setting the prices on their merchandise in the first place. They chose that price that they’re discounting from, most likely by determining a cash price, then increasing that price by the amount of their posted prompt payment discount to set a net 30, 45, or 60 day price. In reality, the “prompt payment discount” or cash price is the real price of the goods, and the amount of the discount is actually your cost of using trade credit.
Late Payment Penalties
A single cash flow scare caused by late-paying business’ is usually all it takes for vendors to wise up to the importance of including late payment penalties in their invoicing terms. In fact, some accounting professionals would suggest that if your invoice doesn’t include a late payment penalty, it doesn’t really have a due date! As a result, it is not at all uncommon to see invoices from vendors that include a 10% or even 15% penalty charged on all overdue invoices.
Of course, it goes without saying that you want to avoid late payments at all cost—not only because of the hefty penalty or the fact that paying late might damage your relationship with your vendor—but depending on the vendor’s credit reporting policies, a history of late payments could make its way to your business credit report and jeopardize future financing opportunities for your business.
If ever you find yourself in a position where you might be forced to pay a vendor after the invoice due date, always contact the vendor in advance to explain the situation. Suppliers are far more likely to show understanding if you let them know what’s going on and offer a solution.
On the flip side, if you have stellar payment behavior, see if your supplier will report to the business credit bureaus—it may help improve your business credit scores. Not all vendors will do this, but popular suppliers like Uline, Quill, and Grainger do report to business credit bureaus.