Trade Credit Finance: The Advantages and Disadvantages
Trade credit finance is the term for a system established between the vendor and buyer. It is where the buyer doesn’t have to pay immediately and the. Vendor specifies when the debt must be paid. It is important to know about trade credit and its advantages and disadvantages. This will provide an insight into trade finance well what it entails.
What is trade credit?
Trade credit enables importers and exporters to engage in global trade by providing the necessary finance. This finance enables businesses to pay for goods or services on time and prevent the possibility of defaulting. Trade finance is offered by different organizations, from small non-bank financiers to large finance institutions. An LC, or Letter of Credit, is a tool of trade finance. This is a promise offered by a financial institution to pay the exporter once the services or products meet the contract agreement. The importer must provide an LC to the exporter before the deal is completed.
Trade Credit – the advantages and disadvantages:
The advantages of trade credit
Drives business growth
Trade businesses must balance the risk of non-payment and the ability to pay for products and services. Trade finance can be considered working capital for the short to medium-term. It offers security when importing or exporting.
Reduces risk
Trade finance reduces the risks associated with credit and payment. It helps suppliers to fulfil bulk orders. Trade credit finance focuses on the goods and the trade cycle rather than the borrower. This means even small-sized businesses can trade large volumes through credit.
Can Increase revenue and margins
Trade finance enables supplier companies to increase the order size potential and boost revenue and margins.
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Can Reduce the risk of bankruptcy
Challenging creditors and debtors with deferral in payments can have a negative effect. Trade credit facilities ease the pressure on cash flows and help to avoid problems.
Diversification of the supplier network
The global marketplace accommodates manufacturers, distributors and traders. Trade finance increases the flow of money into the system. This allows business owners to diversify their supplier network and maintain risk mitigation structures. Trade finance drives efficiency in markets while boosting competition. It creates a safer framework for increasing trade volume.
Discounts for fast payments
Many trade credit agreements offer a discount when a business pays within number of days. For businesses with healthy cash flow, it is beneficial to pay invoices early. These discounts provide increased profits.
Lower spending
Trade credit financing provides the capital to increase stock. Trade credit finance can be used as working capital for infrastructure improvements, payroll or for liquidity.
Provides a competitive advantage
Securing goods on credit provides a competitive advantage. This confers the ability to meet market demands and remain agile. Through trade finance the business can ensure it has a constant supply of goods.
The disadvantages of trade credit
Trade credit can be rescinded
Vendors have no obligation to provide credit. Some will not provide credit until there is a regular payment history. If a company is habitually late making payments, the vendor may require cash on demand.
In extreme situations, vendors will sever ties with businesses that have failed to make regular payments. Sometimes the trade credit facility will be rescinded.
Penalties and fees
Discounts are available for early payment. Penalties may apply for late payments, which may be charged at 1 to 2 per cent.
Product quality risks
Sellers may try to mitigate risk by covering contractual responsibilities like agreed service levels, warranties or maintenance. Buyers may try to reduce risks related to external factors like unfavourable weather conditions during shipment or negligence at the production stage. Even after contracts are signed by both parties, quality can still be a reason for disputes. The issue can be resolved by approaching inspectors or going for bonds or even certifications.
Transportation risks
Choosing a reliable freight forwarder and securing cargo insurance can help to reduce transportation risk. If the product is not properly insured by the buyer then insurance may be invalidated in the case of damages.
Manufacturing risks
The cost of making modifications to a product is generally covered by sellers. This is common especially when products are tailor-made for unique needs.
Currency risks
Businesses of all kinds can be impacted by the exchange rate which can directly affect profit margins. It is always important to have an understanding of the possible impact of foreign exchange on the business.
Bad debt risks
Late payments are an issue in trade finance. Non-payment is a critical issue. Businesses using trade credit may cease trading or may stop making payments. In such cases, the losses faced are written off as bad debt. It can be beneficial to use trade credit insurance so to insure against such bad debts.
Cash flow issues
Cash flow problems can occur when buyers don’t pay or make late payments. Outstanding bills can be an issue for suppliers who must pay creditors while trying to secure overdue cash from buyers. It is essential to ensure sufficient liquid cash and ensure not to extend credit.
Summary
It is important to understand the advantages and disadvantages of trade credit. If the business is considering a trade credit facility, it is advisable to be aware of the details.
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