Trade Credit and AP

Trade credit is the arrangement by which a supplier allows a business to receive goods or services now and pay for them later -- typically within 30, 60, or 90 days. It is the most common form of short-term business financing and the foundation of the accounts payable function. The entire AP process exists because of trade credit: without it, all supplier transactions would be cash on delivery, and accounts payable would not exist as a balance sheet category.

Trade credit creates a financial relationship with the supplier that extends beyond the individual transaction. Suppliers assess a business's creditworthiness before extending credit and set a credit limit -- the maximum outstanding balance they will allow at any time. The credit limit determines how much the business can owe the supplier at any point; once the limit is reached, the supplier will typically not ship further goods or commence further work until some of the outstanding balance is paid.

How AP manages trade credit accounts

Managing trade credit effectively means paying within terms consistently enough that suppliers maintain and ideally increase the business's credit limit, while using the full credit period to optimise working capital. A business that consistently pays 10 days before the due date is not optimising its credit facility. A business that consistently pays 15 days after the due date is damaging its credit rating and risking tightening of terms.

AP teams that track payment performance by supplier -- and flag when a key supplier account is approaching its credit limit or when payment terms are at risk of being breached -- are providing a supply chain risk management function as well as a financial processing function. A supplier who reduces the business's credit limit or moves it from net 30 to COD terms because of consistent late payment is creating an operational and cash flow problem, not just an AP administrative one.

Trade credit as a financing tool

For businesses with tight working capital, trade credit from key suppliers can function as an interest-free short-term financing facility. Deliberately negotiating longer payment terms -- say, extending from net 30 to net 60 -- with major suppliers provides 30 additional days of interest-free financing on the spend with those suppliers. For a business spending AU$1 million per month with a key supplier, the move from net 30 to net 60 is equivalent to a permanent AU$1 million interest-free working capital facility.

Supplier financing programs (also called reverse factoring or supply chain finance) extend this concept: a financial institution pays the supplier early on behalf of the buying business, and the business pays the financial institution at a later extended date. The supplier gets faster payment; the buying business extends its payment cycle beyond what the supplier would directly agree to; the financial institution earns a spread. These programs have become more accessible to mid-market businesses and can be a valuable tool when negotiating longer payment terms directly is not possible due to supplier power imbalance.