Every single business owner out there would love nothing more than to have all their sales on a cash basis. Unfortunately, this isn’t always an option in today’s competitive marketplace. There are times when a business must offer sales on credit terms to get customers interested in purchasing their products/services.
However, when businesses sell on delayed payment terms, it opens up an entirely new area of running a business: managing the extension of trade credit to consumers. In this article, we’ll discuss the advantages and disadvantages of extending trade credit to your customers.
Advantages of Trade Credit
Here are some of the advantages of trade credit:
When a customer doesn’t have to come up with cash out of pocket for something, they are much more likely to make a purchase. Businesses will most commonly offer 30-day credit terms- however, you may see them extended beyond that- but this is rare.
When business owner extends credit to their customers, they are letting the customer know that they are believed to be trustworthy and will pay their bill when it comes due. Then, the buyer rewards that by continuing to purchase from the business.
When a business can extend trade credit to their customers, it gives them an advantage over the competition that is unable to offer this option. This makes sense because, of course, a customer would rather purchase from a business using credit than have to pay cash out of pocket for everything.
Incentives for Customers to Pay Early/On-Time
Often, when businesses offer a trade credit line, they encourage their customers to pay early by giving them a discount. For example, if they offer a 30-day term, they may give them a 2% discount for paying within 10 days. This is a major incentive for customers to pay it off early. If they don’t, they are paying high-interest fees.
Disadvantages of Trade Credit
Of course, there are also some disadvantages of trade credit. Some of these are as follows:
Creates a Gap in Cash Flow
The biggest disadvantage is that it created a gap in cash flow. This is because they’re not getting the cash upfront. The issue is they must learn to balance the lack of cash flow with the need to pay bills.
Investigating Creditworthiness of Customers
Just like a bank, any business that is going to extend trade credit to their customers must investigate their creditworthiness. This takes time and money. An additional person with experience in analyzing credit may be required to make these decisions.
Monitoring of Accounts Receivable
A business offering trade credit is going to need to hire someone that can keep an eye on the accounts receivable records to make sure that everyone is paying on time. If the business operates on a cash-only basis, they don’t have to worry too much about this.
Financing of Accounts Receivable
By extending trade credit to their customers, the seller must finance the receivables. They may have to lean into their suppliers for a line of credit, borrow from the bank, or use any retained earnings of the business.
Potential of Bad Debts
When a business extends credit to a customer, there’s always a chance that they won’t pay their bill. If this occurs, a person who is dedicated to making collection calls needs to be hired.
It’s common for businesses to extend trade credit to their customers- but it does involve risk and spending extra time and money monitoring and collecting on these credit lines.
If you need more help deciding if you need to extend trade credit to your customers, call Porter Capital Group to learn more.