Doing business is easier when trade credit can be established.
Trade credit is the amount a company allows business customers to purchase on credit, usually for a period of 30 days. Trade credit allows businesses to purchase products from each other simply, without requiring payment in advance. The amount of trade credit assigned to a customer depends on how much is purchased in 30 days, the customer's ability to pay and the vendor's appetite for risk.
Determing How Much Trade Credit a Customer Needs
Determining how much trade credit to allow a customer requires knowledge of how much the customer plans to purchase in 30 days. For example, an owner of a convenience store who buys fuel for his pumps may require $50,000 in trade credit. An owner of a hobby store may need $1,000 in trade credit from her yarn supplier.
Determining How Much a Customer Can Pay
Vendors must determine a customer's ability to pay back trade credit in 30 days. Typically, a credit analyst will determine this amount based on a customer's payment history with other vendors and the company's financial stability. Credit reports for companies are offered by Dun & Bradstreet, Standard & Poor's and Moody's. A credit analyst determines financial stability by calculating financial ratios such as working capital, quick ratio and debt ratio.
Determining How Much Risk to Absorb
When a company allows its customers to buy on credit, there is a risk that the customer may not pay the amount back. Some companies are willing to absorb more of this risk than others. Small companies with limited resources could be bankrupted by one customer's defaulted payment, while larger companies with more liquidity could offer larger credit lines to riskier customers.
Who Decides How Much Trade Credit to Offer?
Most companies have one or more dedicated credit analysts to manage trade credit for customers. Credit analysts gather information about customers to determine how much of a credit line to offer. Some companies base decisions on a customer's payment history with other companies. The credit analysts will request that the customer provide trade references. Trade references are other companies with whom the customer has an established credit line. A credit analyst may also ask for permission to speak to someone at the customer's bank. A bank officer will provide verification of the company's ability to pay by providing the amount of the deposit balance, the age of the banking relationship and the number of times the account has been overdrawn.
Performing a Financial Analysis
In some cases, a vendor will request that a business customer provide financial information. The customer may provide a balance sheet, income statement and a statement of cash flows. These statements allow a credit analyst to perform an in-depth financial analysis of a company. With the income statement and balance sheet, a credit analyst can determine the average number of days it takes for a company to pay its bills. With the statement of cash flows, the credit analyst can determine if payments to vendors have sped up or slowed, indicating whether the company was stretched to pay its vendors. Finally, the income statement shows whether the company is profitable, indicating a viable future.
