Why trade credit is necessary for the steel industry

How does trade credit benefit the steel industry and MSMEs, especially during the pandemic. 

Key Takeaways:

• Trade credit is an essential part of doing business, regardless of sector

• It allows different players in the value chain to seamlessly do business without the need to raise short-term finance

• In sectors like steel, where the cycle from purchasing the raw material to realising payment on the finished product is long, trade credit is a boon, especially for small businesses

No matter what business you are in, some of your transactions are probably on credit. If you are a manufacturer, you may be buying your raw materials on credit, and your clients are most likely taking your finished product on credit. Trade credit lubricates the engines of economic activity by giving downstream partners the time to create products and realize the value of those products from end customers.  

At a basic level, trade credit is simply an arrangement that lets buyers take the goods they need from sellers without paying cash up front. Depending on your business and arrangement with your suppliers, you could get credit ranging from 30 to 90 days. But just as you get to enjoy the fruits of credit, your downstream partners such as clients and customers would expect a similar courtesy. 

In the face of strict lockdowns and restrictions on movement following the outbreak of the pandemic, several industries faced contractions, including the steel industry. While the industry is showing signs of recovery in 2021, many enterprises, especially MSMEs, are relying on trade credit to get through this trying time. 

The formal sector does not lend easily to small businesses. Without access to short-term credit from banks and financial institutions, small businesses often resort to borrowings at high interest rates, which eats into their margins and profits. The pandemic-induced lockdowns and the consequent demand contraction have made matters worse as many of them are saddled with unsold inventory.

Trade credit works on trust and relationship-building. Yes, most enterprises have contracts and agreements, but the system works best when there’s a rapport and understanding between the supplier and manufacture and the customer. 

Other short-term financing options

Trade credit is the first resort for short-term financing because in most cases it has no interest or cost attached as it involves no paperwork, is based on trust and is easy to avail. But trade credit does have some drawbacks. The same raw material can be bought at a lower price if bought with cash and trade credit markups are oftentimes opaque and high. Thus, if the arrangement isn’t a fair and transparent one, trade credit can become quite expensive for an enterprise.

Businesses often need to resort to other financing options too to meet their short-term needs. These include business loans or an overdraft facility. Apart from these, the most common option is receivables financing.

Receivables are all the payments that are due to a company in the future. And raising money against your receivables is called receivables financing.

One of the most popular types of receivable financing is bill discounting. What is bill discounting?

Let’s say you are a manufacturer and have sold goods to customer A and have raised a bill or invoice. Customer A has a trade credit with you of 60 days. But you need funds to buy more raw materials and can’t wait till A’s payment comes in. You can, however, use your invoices to A to raise money from a bank or financial institution. In simple terms, the bank pays you a discounted amount in advance and collects the entire amount from customer A. Let’s say, the value of your invoice is Rs 1.10 lakh. The bank will pay you Rs 1 lakh against the invoice. And then collect Rs 1.10 lakh from customer A when the payment becomes due.

Receivables financing allows businesses to immediately deploy money that is due to them at a later date into productive activity.

Differences between trade credit and receivable financing

Trade Credit:

• An agreement between B2B buyer and seller

• Allows a business to buy now and pay later

• Usually, no interest is involved. Credit mark ups and related cost are opaque

Receivables financing:

• An agreement between a businesses and a lender

• Allows a seller to collect money against payments that are due later

• Comes at a cost -- interest or discount