Small, new businesses are extremely fragile. A single missed collection of cash from customers can leave an entrepreneur short of the money he or she needs to buy the next day’s supplies. One unexpected adverse event can wipe out a day, a month or a year's earnings. And if ready cash can't be found to pay suppliers or staff, the business grinds to a halt. For all the benefits of funding your business through the cash it generates, there is some amount of risk involved.
What is the pathway out of this precarious state? The answer is credit. And often the safest, cheapest and most common form of credit is trade credit. This is where a supplier holds off from requiring cash payment upfront, and instead allows the customer to pay later - albeit with a little interest surcharge.
This is so common that various sectors, industries, supply chains may treat 30- 60- or 90-day payment terms as the norm. Indeed you might find that the quoted price for a business-to-business transaction is based on a 30-day payment term, coupled with an offer of a discount to customers who pay cash upfront. (This is of course functionally the same as the interest surcharge, just framed differently.) But credit is only extended to those who can credibly demonstrate that they will generate the cash they need, soon.
The “flavour” of Trade Credit
Here are some things about trade credit that are great. Like cash, it’s available immediately. Delaying the need to pay a supplier involves no transaction costs because the money stays in your pocket. Restrictions are minimal - the cash that remains in your pocket can be spent however you want. And the price is reasonable and responsive to circumstances.
The “price” of Trade Credit, and why it’s possible that it is good, fair and true
Let’s talk about the “price” of trade credit for a minute. What is the price of trade credit? It’s the difference between what you would have paid in cash, and what you will actually end up paying. We can do math on this in another post, but for now let’s look at the circumstances of how that price is set. Here are some of the factors:
- The supplier probably understands the market that he and the buyer are members of
- The supplier can observe the buyer’s business - whether it is trucks in the parking lot, gossip from the factory floor, news of bids won and lost, there is a lot of fresh information available, either directly or indirectly
- Trade credit is a high-frequency activity that allows for rapid information discovery and iteration. Trade terms can be tweaked from month to month (or even week to week!) to respond to new information, and to reflect growing (or shrinking) confidence in a business.
There are plenty of reasons why unhealthy trade credit relationship can exist. But I would say that trade creditors are at least in a position to make good credit decisions about the businesses they sell to.
The accounting story
So where does trade credit “live” on the financial statements? Let’s start by noticing where it is not. You won’t find trade credit on the cash flow statement - it is valuable precisely because you have received your supplies, and you haven’t yet had to put any cash down. It will however still show up as an expense on your income statement, thanks to the wonders of the accrual method of accounting.
The next place it will show up is on the balance sheet, under “Accounts Payable”. And because trade credit is typically extended for 30, 60 or at most 180 days, your accounts payable will typically be grouped together with other short-term liabilities (those obligations with a timeline of less than a year.)
So is this a loan?
Kind of! This is effectively a loan from a supplier, and for those of you who insist on thinking like bankers, it’s basically a zero-coupon bond.
So why don’t they talk about it at law school when we learn about debt?
Because this kind of simple, sensible, responsive and cheap method of financing a business can be handled by mere mortals without the assistance of a lawyer. There are no covenants, restrictions, and indeed no additional contracting. There is really not much lawyering to do.
But why are you making such a big deal out of it?
Because it is one of the most important sources of funding for most businesses in the world. It is a big, big piece of any funding puzzle, and any transactional work you do for a company will take place in the shadow of the relationships that the company has with its suppliers, and the money it potentially owes to them.
We mentioned in the introduction that great lawyers can speak the language of business, and the vocabulary of trade credit is one of the most important things you can pick up. If cash is the lifeblood of business, then working capital is the oxygen. Any business creature that has evolved beyond a Protozoa relies on it - and though it’s possible for creatures to hold their breath, no one can do it forever.
When trade finance grows up: Factoring, liens and supply chain financing
“But how dare anyone do anything important without a lawyer present?”
Don’t worry. Trade credit has a bunch of grown up siblings, all of which start to look like the beloved debt instruments that generate all those juicy billables.
First: Liens on receivables. This involves looking at the value of the Accounts Receivables on the balance sheet, and collateralising those assets so that more cash can be provided to the business in the form of regular secured loans.
Next: Factoring. This involves taking ownership of the receivables - similar to buying a loan portfolio - in exchange for cash.
Finally: Supply chain financing. This term includes all of the above and more, as part of a suite of tools and strategies to help companies produce and sell as much as they can, without hitting cash and payment constraints.
These topics do not actually belong in this section, because they don’t involve taking a loan from a supplier. But they are the grown-up siblings for which grown-up contracting is required, so you should know about them.
Excited?
You should be.
I like to overdo my metaphors, so here’s another one: Trade credit is the background radiation of the commercial universe, a constant hum of trust relationships that keep funds and goods moving at a speed and with a fluidity that even the most lovely and unobtrusive contract cannot match. It’s that very ubiquity that make it catastrophic when credit seizes up in the supply chain.
If you want to be a great business lawyer, you really really need to be comfortable navigating the A/P and A/R lines on the balance sheet. There’s gold in them hills, and your clients will be impressed and grateful if you understand that.