According to the World Trade Organization (WTO), about 80% to 90% of world trade is dependent on short-term trade finance. And this is often the case in the construction industry.
Trade credit is a standard financing option for contractors and construction companies to obtain supplies and keep their projects moving.
This article will discuss why construction business owners should be thinking about building their trade credit. We’ll share a few tips on how to build your trade credit, where to start, and how to maintain a solid trade credit rating
What is Trade Credit in Business?
Trade credit (also known as supplier's credit) is a common financing practice in construction. It is the simplest and one of the most commonly used sources of short-term financing in business
Construction businesses can purchase materials and equipment from suppliers without laying out the cash upfront. Typically, the payment for these purchases is due 30 days from purchase.
Trade credit usually involves a supplier providing building materials to construction companies with sound business relationships. Suppliers typically don’t extend credit to everyone, only those with a proven track record.
Trade credit can be compared to a short-term unsecured loan with a 0% interest rate.
Alternatively, a bank loan is where a percentage of interest will be charged in addition to the total amount. Suppliers will even offer payment discounts to encourage early payments in some trade credit cases.
An example of extended trade credit is when a building materials supplier provides sheetrock or drywall, typically costing $3000 to the construction company on a building site, despite the contractor not having the cash on hand.
Therefore, the supplier agrees to provide the materials under 'Net 30' terms, which means that the construction company/contractor has 30 days from the day of the purchase to pay off the $3000.
Each day of the week counts in trade credit agreements, including weekends. For example, If a "Net 30" agreement is made on the 1st day of a month, the full payment is expected on the 30th day.
Another trade credit scenario is where the supplier provides 200 lbs. of building supplies, which costs the company $4000. The agreement terms are "2%/10 net 30" or "2/10 net 30".
It means that the supplier has offered a discount to facilitate the early repayment of the invoice. The terms translate to a 2% discount on the $80 if the payment is made within ten days.
Therefore, the amount the construction company/contractor has to pay has been reduced to $3920 if they make the payment within the first ten days of the agreement. If not, they will have to pay the full invoice of $4000 even if they now have the money on the 11th day.
Construction companies who build their trade credit can make extra profit and build great relationships with their suppliers.
In other cases, interest may be charged where the trade credit is not repaid in a short period.
What are the Benefits of Building Trade Credit as a Contractor
This section will look at the advantages and benefits of building trade credit for your general contracting business.
1. Better Financing Options:
The most important benefit of trade credit is that it provides an easy to access short-term financing option for construction businesses. Trade credit terms are far more favorable when compared to bank loans and other means financing.
2. Helps to Manage Cashflow:
Trade credit gives general and service contractors a means to purchase building materials without spending any money upfront, thereby putting less pressure on cash flow.
Establishing your trade credit can provide flexibility to pursue additional projects.
3. Build and Establish Relationships with Suppliers:
Trade credit helps to foster good business relationships amongst contractors and suppliers. Long-term relationships facilitate completed projects that add to the portfolios of construction companies and contractors, making them more likely to be awarded contracts in the future.
4. Helps to Negotiate Better Terms:
Having an established business credit allows construction companies to negotiate better terms with suppliers in a competitive market. It, in turn, has an overall positive effect on the company's cash flow, especially in a competitive market.
What are the Advantages of Trade Credit?
- Trade credit gives contractors access to easy short-term funding with no extra cost.
- Construction companies can take on larger projects by utilizing their trade credit, thus fueling their growth. In addition, they can procure the materials needed to complete large projects even if they don't initially have the capital to take on projects of that scale on their own.
- Additional profit can be made when the discount option on early repayment of trade credit is exercised.
- It fosters good business relationships between the contractors and the suppliers.
What Are Some Downsides of Trade Credit?
Though trade credit typically has numerous advantages, there are a few drawbacks to using this form of financing.
- It is difficult for new businesses to build trade credit. Since trade credit relies on the excellent standing between supplier and contractor and a good repayment record from previous credits —it is sometimes hard for companies with no consistent trading history to secure. And when they do obtain trade credit, the terms may not be as favorable for them as for other more established competitors.
- It may not help in establishing a business credit history. Typically, suppliers don't report on-time payments to business credit bureaus, so years of positive payment history are not benefiting their trade credit score.
- Defaulting on a supplier payment can come with stiff penalties like added interest and late payment fees. What was initially a 0% loan can turn into an expensive debt that will reduce your profits. It also harms the business credit rating of the company or contractor, which in turn makes it harder for them to leverage their trade credit.
- Another disadvantage of trade credit is that suppliers may choose to sever ties with contractors or construction companies that struggle to make payments on time, even if it is only for a short period. It can leave the contractors in a bind to find new suppliers and meet customer demands and deadlines.
How Can You Build Your Trade Credit?
Building trade credit or business credit is essential for any construction company focused on growing the business.
Building trade credit requires a company to understand the things that affect their credit scores. Here are a few steps that will ultimately help improve construction business owners' build their trade credit profile.
1. Establish and Register your Business
The first step on the road to building your business credit is to legally establish and register your business with a name and dedicated business phone number, email, and, if possible, address. It makes the company appear more professional and credible.
You will need to decide on the proper business structure, be it a sole proprietorship (as an independent contractor), a corporation, or a Limited Liability Company (LLC), and then register the business in your state accordingly. All accounts opened with banks and vendors that report to credit reporting agencies have to be in the company's legally registered name.
2. Obtain an EIN
The Employer Identification Number, which can be likened to a social security number for business, is what the government uses to identify your business.
After getting your EIN from the IRS, you can use it for several processes, including applying for licenses and permits, opening a business bank account, and filing tax returns.
3. Open a Business Bank Account
Opening a bank account specifically for your business is crucial in building trade credit. Setting up a business bank account helps obtain a business credit card and establish a relationship with the bank.
4. Establish Credit Accounts with Vendors that Report to Business Credit Agencies
Opening accounts with vendors and suppliers that provide construction materials are beneficial. Regularly buying goods on trade credit (net terms) and promptly paying back each time will build your company's credit profile.
The credit reporting bureaus that your vendors report to will have access to your payment history and use it to determine your business credit score.
5. Open and Use A Business Charge Card
After opening your business bank account and commencing your business in full swing, it is essential to open a business charge card and use it smartly.
You can pick the charge card you use based on the type of business you're trying to run and the card's incentives, such as cashback or travel rewards that may benefit your business. It is worth noting that your charge card limit may be low initially, but it will increase over time as you build your trade credit score.
Established construction companies can also register and sign up for construction-specific charge cards such as Toolbox to access additional working capital while building your business credit.
6. Monitor your Credit Reports
It is essential to pay attention to each of your company's credit files handled by the three major business credit reporting agencies. Each agency gets data about your business from different sources. Therefore, it is worth keeping an eye on your ratings on each one so you can regularly update information about your business and contest any discrepancies.
Monitoring your credit reports lets you see where your business credit rating currently stands. In addition, it informs you on whether you have to make any changes to how you're carrying out your transactions.
Toolbox reports to credit bureaus every month, helping contractors build their business credit.
Final Thoughts
Trade credit is one of the most widely used financing options for contractors and small/new construction companies in the building industry, and it is pretty obvious why. The numerous and widespread advantages make it a desirable way to fund projects, an integral part of trade and construction in general.
One of such steps is building a solid trade credit rating and maintaining it. Substantial trade credit will enable contractors and construction companies to put structures that protect them from trade credit risk.
Funding, insurance, and growth are possible with a good trade credit score. Therefore, it is clear that trade credit and building trade credit are crucial to the survival and success of contractors and construction companies.
