Effectively Using Debt Finance, Trade Credit and Supplier Finance in Your Business

Trade credit can be an excellent way to generate quick, flexible business capital, yet it can be costly. Understanding debt finance is crucial so you can determine what you can qualify for and if your debt ratios are satisfactory. If you use trade credit and debt finance together, you can highly leverage your business capital, but you must be careful not to over extend yourself. This article explores both areas of business finance so you fully understand how they work, what the risks involved are, and how to efficaciously use them. As a Business Consultant, I see a lot of companies who don’t understand how debt and trade credit really works in relation to their business, leaving a lot of opportunity for some better management.

Things to Consider When Using Trade Credit and Supplier Finance

Trade credit and supplier finance is great for meeting short-run capital needs quickly and with less red tape than other short term finance instruments.

The Costs:  Can be high cost. Supplier Terms of 2% Cash Discount within 10 days, net 30 days.  By not taking vantage of the Discount, the Company is allowing use of its money for an additional 20 days at 2%.  On an Annualized basis, this is equivalent to a 36% Interest Rate. Late Payments can run 1-1.5%, monthly basis, which annualized is the equivalent of 12-18% Interest Rate. If used effectively for short-term needs, the higher costs connected with Trade Credit can be justified.  Over-reliance on Supplier Credit and using it as an medium or longer term finance need will significantly hamper Cash Flows and Growth

The Risks:  Suppliers can cut off credit at any time or ask you, upfront cash payments during difficult business periods. A solution could be adopting your Key Supplier as a small Equity Investor, which promotes more flexible finance terms during cash strapped periods.  The Supplier has a better understanding of your potential upside as an Equity Investor.

Flexibility Issues: Be careful of Suppliers offering Extended Payment Terms as you can get locked in or over attached to these suppliers, overshadowing other Suppliers who offer lower prices, a better product and more dependable delivery.

Control:  Can lose effective Control of Company Operations if Trade Credit was over-extended to such a level where your Suppliers take Legal Action, which can lead in attaching Assets and forcing the Company into Receivership.

Availability:  This is a short-term need and your short-term Strategic and Cash Management must be up to the task. Can be significantly curtailed during Economic downturns; therefore, having a backup Line of Credit is mandatory.

Short-Term Needs: Best utilized for small, short-term needs. Necessary to have excellent Planning in place to avoid unneeded costs, such as forfeiting Cash Discounts or incurrence of Delinquency Fees.

Business Debt Finance Considerations

Timing:  The money market may be tight so having a well developed Business Plan is essential toward obtaining Debt. Banking relationships are Key when times are tight in the lending markets. Having a well prepared Loan Package is also essential.

Financial Condition: A strong Equity Component in your Company’s Financial Structure will promote a Debt Ratio which is amendable to a Bank or Commercial Lender

Stability:  A company’s capability to withstand periods of lower earnings or losses without defaulting on Debt Obligations. A Company’s ability to carry more Debt.

– Ratio Analysis:

• Debt-Equity Ratio = Total Liabilities divided by Total Equity.  Compare to Industry’s Average to determine an Acceptable Threshold.
• Debt Capacity = Acceptable Debt to Equity Ratio x Equity.  Estimate the amount of Debt that a Company can carry based on its Equity Strength. 

Liquidity: Company’s ability to meet short-term obligations. Relationship between Current Assets & Current Liabilities.

– Ratio Analysis:

• Working Capital = Current Assets – Current Liabilities.
• Current Ratio = Current Assets divided by Current Liabilities.
• Acid Test = Quick Assets divided by current Liabilities. Can be converted to cash in 30 days. Indicates the adequacy of a Company’s Short-Term Capital position.

Long Term verses Short Term Debt:  Liquidity Analysis can indicate whether a Company should obtain Short Term or Long Term Debt. Short Term Loan reduces the Current Ratio, while Long Term Finance often improves the Current Ratio. The trick is to find the right mix between Short-Term and Long-Term Debt to meet Stability and Liquidity thresholds.

Using Collateral:  The Quality and Quantity of Collateral both matter equally. Free and Clear Collateral, not encumbered by excessive Liens. Understand how to Package Collateral Classes and leverage Cross- Collateralized Assets.

• Receivables Factors:  Aging, Customers’ Credit Standing and Bad Debt History.
• Inventory Factors:  Market Value Determination, Sales Track Record and Turnover.
• Equipment, Machinery and Real Estate Factors:  Market Valuation, Repayment Ability and Disposability of Assets.

About The Guest Author – Frank Goley, Business Consultant

Frank Goley has an experienced background working with small and medium size businesses as a business consultant, business turnaround consultant, business plan writer, business plan expert, small business consultant, business coach, business plan consultant, marketing consultant, business planner and online marketing consultant, and seo consultant for ABC Business Consulting. He has been helping companies to succeed for many years. Frank wrote his first business plan over twenty years ago. He is an expert in developing business plans, marketing plans, funding plans, strategic plans, turnaround plans, web marketing strategies, and project specific business plans. Frank is the author of a business plan book, The Comprehensive Business Plan Workbook – A Step by Step Guide to Effective Business Planning, and he has over 50 published articles and e-books on business success strategies. He also writes the Business Success Strategies Blog and publishes the Business Success Newsletter.