Construction is a cash-hungry business. Because contractors don’t get paid until after they perform their work, they often need to find alternative ways to purchase materials for a project up front. One of the most common types of supplier financing options is trade credit. Trade credit accounts offer low-cost financing to contractors so they can expand their business and take on more work, allowing suppliers to increase sales and build customer loyalty. It has enormous benefits, but it doesn’t come without risk.
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What is trade credit?
Trade credit is the practice of providing building materials to contractors up front for repayment at a later date. It is essentially a 0% interest loan from suppliers to contractors, allowing them to delay payment for building materials or supplies.
Trade credit helps contractors make larger purchases, which helps them expand their business and take on bigger projects. The contractor’s goal is to get paid by their customer before the supplier payment is due.
For suppliers, providing building materials on credit allows them to make larger sales. When contractors don’t have to make an immediate payment for their materials, they are able to spend more. And offering credit to customers improves the chance that they’ll continue to buy from them and helps develop a relationship between the parties.
Credit & payment terms
The amount of time that contractors have to pay their suppliers depends on several factors, including industry standards, credit risk, and the size of the sale. Most suppliers give contractors 30 days or more to make payment in full before they charge additional costs, like interest and late payment fees.
Before issuing a credit account, suppliers will prequalify a contractor by reviewing their financial records and payment history to determine their credit risk. Most suppliers have a credit policy that outlines their requirements to issue an account and details the terms of payment. Contractors with a higher credit risk may have a reduced purchasing limit, higher fees, or they may be required to pay COD (cash on delivery).
Many suppliers offer contractors discounts to encourage early payment. Discounts are usually given when payment is made within a certain timeframe, such as 7 to 10 days after a purchase. If a payment is not received within the early timeframe, the full amount of the invoice is due within the terms of the credit agreement. Discounts allow suppliers to encourage contractors to pay early, which helps their cash flow. Contractors can take advantage of early payment discounts to increase their profits.
If payment is not made within the terms stated in the credit agreement, interest and late fees are usually assessed by the supplier. These fees can add up if payment is not made by the contractor within a reasonable amount of time.
Benefits for contractors
Trade credit accounts allow contractors to delay payment for materials and supplies. This helps improve their cash flow, as they don’t have to outlay money before they get paid by their customer.
Since they don’t have to spend the money today to get the materials they need to start a project, contractors can use their cash for other project expenses. The ability to secure trade credit can allow them to take on larger projects, earn increased profits, and further expand their business.
Trade credit is often offered with 0% interest if the balance is paid within the terms of the credit agreement. It offers contractors free money to use to pay other expenses, such as overhead costs. Other financing options, such as building material loans or credit cards, typically carry much higher interest fees and shorter repayment deadlines.
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Benefits for suppliers
By offering credit, suppliers allow contractors to purchase more merchandise without having to spend any money right away. This allows them to increase their sales and build a larger customer base.
Trade credit also allows suppliers to improve relationships with contractors and build customer loyalty. By extending credit to contractors, they offer a benefit that will encourage the contractor to purchase from them in the future.
The risks of trade credit
Construction is a risky business, in part because of the payment delays and disputes common to the industry. On average in the US, it takes construction businesses almost 90 days to get paid for work or materials — if they get paid at all.
If a material distributor gives a contractor $100,000 worth of materials on credit, they are taking a gamble that the contractor will earn enough cash on the project to pay it back by the time it’s due.
Suppliers don’t want to carry all of their customer’s risk. As a result, they don’t provide trade credit to every contractor that walks in the door. Just like a credit card company, they have a process to assess a potential customer’s risk, and decide whether to give them credit or not.
Supplier tools to reduce credit risk
Construction has one of the highest rates of business failure of any industry, and cash flow is the number one reason why. If a material supplier extends too much credit to contractors with cash flow problems, they can put their entire company at risk.
A supplier’s credit manager has a number of tools to reduce this financial uncertainty. In addition to requiring a contractor to fill out a credit application, they also often take additional steps to protect their payments. In nearly all states, suppliers have the right to file a mechanics lien on the project’s property if the contractor doesn’t pay their bill.
Using their lien rights as security actually allows the supplier to extend more credit, make more sales, and maintain protection for their own cash flow. They may also require their customers to protect their own lien rights — because if the contractor is having trouble getting paid, the supplier will bear the financial burden as well.
Trade credit has advantages — and risks
Both contractors and suppliers benefit from using trade credit. For contractors, it offers an interest-free financing method that helps them keep cash flowing on a project. For suppliers, it encourages customer loyalty and increases sales volume.
But the practice of extending trade credit carries significant risks for companies in the lumber and building materials industry. By using payment and credit tools to mitigate these risks, material suppliers can extend trade credit safely, build lasting partnerships, and keep cash — and materials — flowing.