Your suppliers are extending you trade credit whenever they allow you to purchase their goods or services without making you pay for them at the time of purchase. Trade credit allows you to defer your cash payments to your suppliers in exchange for your promise to pay them in the future, according to their credit terms. Using your trade credit to purchase goods or services from your suppliers creates an account payable.
In essence, trade credit is actually a short-term loan with interest-free financing. The amount of the loan is equal to the purchase price of the goods or services you've purchased. The loan's due date is the date you're required to pay the supplier's bill. As an added benefit, no interest is charged on this short-term loan, as long as you pay the bill off according to the supplier's terms.
Just like a loan, using your trade credit creates additional cash resources by delaying cash outflows that would otherwise occur at the time of purchase. For this reason, taking full advantage of your trade credit is an important step in managing your payables and improving your cash flow. The average payable period indicates how well you're using your trade credit. It does this by measuring how long you use your trade credit before paying your obligations to those who extend you trade credit.
How is trade credit determined? Most of your suppliers will determine in advance the maximum amount of trade credit they are willing to extend to you. The decision to extend trade credit to your business is generally based on the supplier's credit policy. The amount of trade credit extended to you is based on each supplier's estimate of your creditworthiness, and your capacity to pay for your purchases.
If you're a new customer to the supplier, you may have to fill out a credit application, give some credit references, and provide other financial information about your business. If you're an existing customer to the supplier, the supplier's credit decision is based primarily on your past payment history.
If your payment history with your suppliers is a long history of prompt payments, you can expect the supplier to extend to you a realistic amount of trade credit. On the other hand, if your payment history isn't so good, then you might find your suppliers a little less generous when extending their trade credit. In short, use your trade credit, but don't abuse it. Paying your suppliers in a timely fashion, and according to their credit terms, goes a long way in helping your suppliers make favorable credit decisions about your business.
Maintaining your trade credit. It's important that you maintain good relationships with your suppliers in order to maintain your trade credit.
The first step in maintaining your trade credit is to make sure you establish a dependable and consistent payment history with your suppliers. Your past payment history is probably the biggest factor your suppliers will consider when making their credit decisions. With this in mind, maintaining your trade credit could be quite difficult if your past payment history makes it impossible for your suppliers to predict the dependability of your future payments. A consistent payment history with your suppliers, even if consistently late, goes a long way in helping your suppliers feel safe in extending you their trade credit.
Another important aspect to consider in maintaining your trade credit is communication. The more your suppliers know about you and your business, the more likely they will want to continue to extend you trade credit. Communicating with your suppliers may help you get through periods when your cash flow is less than overflowing. During these situations you may find it necessary to pay one or more of your suppliers later than they allow.
If you find yourself in this situation, call and inform your suppliers in advance, before they pick your name off their list of overdue accounts. Be prepared to explain your circumstances for not being able to pay your account on time. It's also a good idea to be reassuring, and offer your honest estimate of when you expect to be able to pay your account.
When notified in advance, you'll find that most suppliers are willing to
extend their credit terms and carry an account past its due date. In the long
run, your suppliers will view these situations as exceptions to your payment
history, rather than your normal payment practice.