M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
When done properly, trade credit can generate more sales for both retail merchants and the suppliers they buy from. There are also other advantages and disadvantages for both parties from trade credit transactions.
Why Trade Credit?
Tom is the purchasing manager for Toytown, a chain of retail toy stores. Tom knows that having a good supply of the hottest and coolest toys in the stores can mean the difference between a good year and a bad one. There is nothing worse for him than running out of the toys everyone wants during the holiday shopping season - that's bad for his job security! Trade credit allows Tom to have products shipped to the stores today, and pay for them at a later date. It is granted by his toy supplier. Tom uses trade credit to make sure he always has the right toys in stock.
Let's look at some advantages of using trade credit:
One advantage is spontaneous finance. Unlike trying to get a loan or credit extension from a bank, trade credit doesn't involve lengthy paperwork and waiting for an answer. Tom and the Toytown suppliers have long business relationships. He makes orders and agrees to trade credit terms with them right over the phone!
Another is that Tom needs no cash up front. Tom has to order stock for the holiday season in September and October. That comes after the summer months, which usually aren't very good for selling toys. That means Toytown's cash levels are very low at a very important time. Trade credit allows Tom to place large holiday orders without the need for upfront cash. What a lifesaver that is!
Trade credit also means more sales for Tom. The biggest advantage for both retailer and supplier is increased sales.
Last year, Tom had some advanced knowledge about Ronnie the robot, a toy robot that could be programmed to pick up things from the floor in a child's room and put them away. Tom knew that Ronnie was going to fly off the shelves, and he wanted to place a very large order to avoid stock outs. He also wanted Ronnie in Toytown's stores before the competition found out about it. Thanks to a trade credit deal from one of his suppliers, Tom was able to make both things happen! Toytown had one of its best holiday seasons ever thanks to Ronnie the robot and trade credit.
Toytown wasn't the only one who had increased sales from Tom's big order. Suppliers and wholesalers are in business to sell products, too, and Tom's supplier also had a good holiday season thanks to the big Toytown order for Ronnie, the mom-friendly robot.
Now, let's take a look at some of the disadvantages that come from using trade credit:
The first is that Tom will pay higher costs. Tom knows that if he misses a due date on a toy invoice from a supplier, it will cost Toytown extra. Many suppliers start the interest clock at between 12% and 24% the day after a payment is missed. That can add up fast.
Suppliers also like to offer discounts for paying with cash, or for paying the balance off early, usually within 10 days. Using trade credit and stretching the payment out until the last possible day will add dollars to Toytown's total inventory cost. Tom likes to take advantage of those discounts; he knows that hot toys like Ronnie will sell quickly and provide the needed cash to pay early.
The biggest disadvantage of trade credit for the suppliers is bad debts. When a major toy store went bankrupt a few years ago, many toy suppliers were left with uncollected debts for toy orders they had filled for the bankrupt company. They are still tied up in court years later trying to recover their money.
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When retailers are late with payments, they can create hardship for the supplier and this results in a loss of good will. The supplier may be counting on that money to cover other expenses, like paying employees. Some retailers will also play games with the system. They wait until after an invoice is due and backdate the date on a postage machine to show that payment was mailed 'on time' when it really wasn't. This kind of unethical behavior creates mistrust and can jeopardize the business relationship.
Tom knows he is the face of Toytown with its suppliers, and he strives to be honest and ethical in all dealings with them. He has even hand-delivered payments as a favor to suppliers who needed the cash right away. Relationships are important in business, too!
The final disadvantage is administrative costs. Both parties need to hire additional staff to draw up the paperwork for trade credit agreements. They also need to keep track of outstanding invoices for when discount periods end and when balances are due. And suppliers need legal staff if court actions are necessary to collect payment from delinquent retailers. These increased costs reduce profits and add to the cost of the merchandise.
Most of these disadvantages can be overcome with honest and ethical dealings between the parties, and retailers taking care not to overextend themselves. Trade credit can be a win for all parties, and make it possible for many consumers to have Ronnie the robot cleaning up their kids' rooms!
Trade credit allows retailers to have product shipped to their store and pay suppliers at a later date. It has a number of advantages for both the retailer and supplier. It offers spontaneous financing for the retailer, and it is much easier and faster than applying for bank credit. It also allows the retailer to obtain inventory without paying for it upfront when cash may be short. This means additional sales for both parties to the transaction.
Disadvantages to the retailer include higher inventory costs since the retailer is using credit rather than cash. Bad debts can be a major disadvantage for suppliers, as can uncertainty about when outstanding invoices will be paid. Both parties also will incur additional administrative expenses tor drawing up and tracking trade credit agreements.
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