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Understanding The Relationship Between Trade Credit and Factoring

If you run a small business, and you’re interested in learning more about trade finance, you’re in the right place. In this article, Niche Trade Credit will take a deep look at two of the most common financial tools used by small businesses, especially those involved with importing, exporting, and global trade: trade credit and invoice factoring.  Let’s get started, discuss these two financial instruments, and talk about how they relate to one another in the world of international trade.

The Basics Of Trade Credit – Credit Extended Between Two Partner Companies

Trade credit is one of the most simple forms of credit in use today, and is typically extended from one merchant or supplier to another partner company. Essentially, it is a business-to-business (B2B) agreement, in which a customer can purchase goods that they need for their business on an account – without paying cash up front, and paying the supplier at a later date.

The commonly known “Net 30” agreement, when a customer has 30 days after the purchase of goods to pay for their delivery, is a form of trade credit. In some industries, 60 or 90 day terms are more common, which allow for increased flexibility.

So, to boil it down, trade credit is the credit that one company extends to another for the purchase of goods and services. Why is this done? It has a few benefits for both parties.

The party issuing the credit may incentivize the partner company by offering them favorable repayment terms if they pay within a certain time. For example, they may get a 2% discount on a Net 90 contract if they pay within 30 days, and a 1% discount if they pay within 60 days. This encourages companies who can pay right away to do so as soon as they can.

The other benefit – for both parties – is that it increases business flexibility, and helps encourage short-term growth. The company purchasing the goods has more time to sell them and recoup the money necessary to pay. If cash flow is good and business is booming, they can pay early and save money – or wait, if things are slowing down and they need more time.

Because of this, the company issuing the credit is able to profit from a relationship with a new customer, while the company to which credit is extended is able to benefit from better cash flow, and a more flexible repayment strategy.

One important thing to note about trade credit is that the company offering the credit is vested in the success of the company to which credit is extended – as their continued profitability is usually important to both parties.

Because of this, trade credit contracts are often much more flexible than bank loans or any other type of credit. However, there can still be penalties and fines applied if a creditor does not repay the line of credit by the agreed-upon time.

Understanding Invoice Factoring – Enhance Cash Flow, Get Working Capital

Invoice factoring (also sometimes known as receivables factoring) is a type of debtor financing, used to purchase accounts from a company, in return for a cash lump sum. This can be a good way to get quick cash, even if you have bad debt on your books – like a number of clients who are not paying you in a timely fashion, despite owing you money for exporter receivables, for example.

Essentially, invoice factoring allows you to sell all of your outstanding invoices for a percentage of the face value of the invoice. The factoring company pays you this money immediately, and will pay the remaining percentage – minus applicable fees – when the client pays them. By doing so, you can get cash for the money you’re owed immediately.

What you’re doing when you perform invoice factoring is selling your accounts receivable for immediate payment – and turning over responsibility for payment collection to the factoring company. This lowers the risk of late payment, and shifts the risk of bad debt onto the invoice factoring company. Invoice financing is often used by companies to trade receivables for immediate cash if the business is having cash flow issues.

Another important factor to know about when learning about invoice factoring is the concept of recourse factoring. In most cases, any company offering invoice factoring will use recourse factoring, to protect their company from the risk of non payment and bad debt.

Recourse simply means that there is an understanding between you and the invoice factoring company that you will buy back any receivables for which the factoring company cannot collect payment. In essence, you, the client, are responsible for covering the cost of any invoices that are not paid by your customers.

The vast majority of invoice factoring transactions include this stipulation. Non-recourse factoring is rare, and this type of receivable financing is typically only offered to companies who have clients with an excellent payment history.

In addition, non-recourse factoring is typically more expensive, and it does not necessarily protect your company from the risk of non-payment. This is because most factoring companies who offer non-recourse factoring apply it only in cases of bankruptcy – if the client simply doesn’t pay, or disappears without paying, you must still buy the invoice back from the factoring company.

How Do Trade Credit And Invoice Factoring Relate To One Another?

Trade credit and invoice factoring are deeply linked – because when you sell your accounts receivable, you’re essentially transferring a contract to another party, and receiving a lump sum payment from them for the invoice.

This is a good way that companies who offer long repayment terms for trade credit – 60, 90 days or more – can get more cash for their company’s day-to-day operations, even if most customers are waiting for the maximum period of time to repay.

Learn More From Niche Trade Credit Now!

We’re one of the leading insurance companies in Australia when it comes to credit insurance services – and if you have questions about invoice factoring, trade credit, or any other related subject, we’d be happy to help you learn more. Interested? Contact Niche TC now!

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