Q&A - Why are trade creditors a source of finance?

When a business buys raw materials, components, services or other goods from another business it will often look to pay for those at a later date. If it is allowed to do so, then that supplier is said to offer “trade credit” to the business. The supplier becomes a trade creditor – someone to whom the business owes money.

The amount of trade credit and the period allowed before the invoice must be settled will vary from industry to industry.

For example, in the building trade, it is common for trade creditors to require settlement of invoices after 30 days. However, it is not uncommon for businesses in some industries to extend the time taken to up to 90 days (3 months).

Trade credit is a short-term, external source of finance. It has several important advantages to a business:

• It is flexible – the amount of credit reflects the value of business done with a supplier

• It is low cost – trade creditors don’t charge interest on the amount outstanding (unless payment is delayed well beyond the settlement date)

• It matches the purchase of goods and services – e.g. stocks can be bought and held for a period, with the finance provided by trade credit rather than cash

A common complain amongst small businesses is the time it takes for their (larger) customers to settle bills. By delaying payment to a trade creditor, a business holds onto its cash balances for longer.

However, by delaying payment, a business has to be careful not to damage its credit reputation and rating. Trade creditors are seen (wrongly) as a “free” source of capital. Some firms habitually delay payment to creditors in order to enhance their cash flow - a short sighted policy which also raises ethical issues.