The advantages and disadvantages of trade credit are important points of consideration before forming any decision relating to trade credit. The key advantage of trade credit is that it is simple to obtain and considered practically cheaper. Trade credit is often considered simple to obtain due to its relatively straightforward nature compared to other forms of financing. Unlike securing a loan or credit line from a financial institution, trade credit typically involves a direct arrangement between the buyer and the supplier.
In this article, I will explore the disadvantages of trade credit from the perspective of both buyers and sellers. By understanding these potential drawbacks, businesses can make informed decisions about their credit practices and seek alternative financing options when necessary.
Disadvantages of utilizing trade credit include loss of goodwill, higher prices of raw materials, the opportunity cost of the discount, administration cost, and under worst circumstances, one may lose the supplier as well. For suppliers, bad debts are the biggest disadvantage, among others.
For Buyers
Opportunity Loss of Discount
Suppliers provide a discount on bill amount if payment is made early or is made in cash. If the buyer enjoys trade credit, he must forego the otherwise available discount.
As clearly explained above, in the advantages of suppliers, the buyers with liberal credit terms are charged premium prices. This increases the cost of raw materials for the buyer, making it a direct increase in the cost of finished goods for the buyer. Finished goods with higher prices are difficult to sustain in the competitive market. We know that price is an important factor in the demand for products. Higher prices may badly impact the demand for the buyer’s products.
Loss of Goodwill
Some managers tend to delay payments till the last point possible. But, they are unaware of the problems posed by their suppliers in the absence of timely payment. Over a period of time, this idea impacts the firm’s goodwill in the market. All the suppliers will come to know about payment delays of the buying firm and will entertain other buyers first. The firm may face problems like late supplies, no supplies in emergencies, etc.
Loss of Suppliers
At times, failure to abide by the terms of credit can cause loss of supplier as well. The supplier may find it challenging to work with the buyers not paying on time as suppliers also have their obligation to pay on time.
Interest Charges
Suppliers often charge interest on outstanding trade credit balances. This means that the longer the buyer takes to pay off the credit, the more interest they will accumulate. These interest charges can significantly increase the overall cost of the purchased goods or services.
Relying heavily on trade credit may impact the buyer’s ability to secure additional financing from external sources. Lenders may view a high level of outstanding trade credit as a liability and may be hesitant to extend credit or offer loans, making it difficult for the buyer to access additional capital when needed.
Dependence on Suppliers
When a buyer heavily relies on trade credit from specific suppliers, they become more dependent on them for their procurement needs. If the supplier faces financial difficulties or decides to discontinue credit arrangements, it can disrupt the buyer’s supply chain and affect their ability to fulfill orders or maintain regular operations.
Limited Negotiating Power
Buyers who heavily depend on trade credit may have limited negotiating power with suppliers. Suppliers who offer credit terms may be less willing to negotiate lower prices or offer discounts, as they already have an advantage by providing credit.
For Suppliers
Risk of Bad Debts
When offering trade credit, there is always a risk that the buyer may default on their payment obligations. If a buyer fails to pay or goes bankrupt, the seller may experience financial losses and difficulties in recovering the outstanding debt. This risk increases with larger credit amounts or when dealing with less creditworthy buyers.
Cash Flow Mismatch as There is No Guarantee of Timely Payment
Offering trade credit to buyers means the seller is extending credit and delaying the receipt of cash for goods or services provided. This can put a strain on the seller’s cash flow, especially if a significant portion of their revenue is tied up in outstanding trade credit balances.
Opportunity Cost for Trade Credit
By extending trade credit, the seller is essentially providing interest-free financing to buyers. This means that the seller is forgoing potential interest income or the opportunity to invest the funds in other areas that could generate returns. The longer the credit period, the greater the opportunity cost for the seller.
Limited Control over Cash Flow
When relying heavily on trade credit, the seller’s cash flow becomes dependent on the payment behavior of buyers. Late or delayed payments can disrupt the seller’s financial planning and ability to meet their own obligations, such as paying suppliers, employees, or other expenses.
Dependency on Buyer’s Financial Health
The seller’s financial stability can become linked to the creditworthiness and financial health of their buyers. If a buyer encounters financial difficulties or goes out of business, it can have a direct impact on the seller’s revenue and profitability.
Cost of a Cash Discount
As part of encouragement to buyers for early payment, suppliers offer a discount for early payment. This reduces their margins on sales.
Increased Administrative Burden
Managing trade credit requires additional administrative work for the seller. This includes maintaining records of credit transactions, monitoring payment deadlines, and following up with buyers who are late or delinquent in their payments. This administrative burden can add complexity and costs to the seller’s operations.
We conclude that there is a cost of trade credit, and it should be quantified, and to our surprise, it can also be quantified.
Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.
helpful