Vendor Financing, also known as trade credit, is a type of a loan, through which a vendor enables a customer to purchase vendor's products or services. It has become more and more common for sellers of capital goods in particular not only to sell the product, but also provide a loan, deferred purchase arrangement or lease arrangement to the customer which is then paid off from the cash flows generated by using the product, directly or indirectly
There are potential benefits to vendors of offering attractives terms of vendor financing, such as stimulating sales and getting larger share of a market.
Forms of vendor financing
Vendor financing might take forms of:
- a loan (for example, selling the equipment on a credit)
- a lease of equipment
- a guarantee of a bank financing (financing is provided at the vendor's risk, not the bank's risk)
An example of trade credit
Trade credit works as follows. Suppose the founders of a company purchase from a vendor, The vendor might give the founders a specified period, the founders are permitted to take a discount from the invoice price. The period in which the founders are entitled to take the discount is called the discount period. Once the discount period passes, the company must pay the full invoice price.
The terms of trade credit are conventionally expressed as 'x/y, net z', where x is the discount percentage, y is the number of days in the discount period, and z is the number of days when the full payment is due. For example, if a company makes a purchase from a vendor of $100,000 based on trade credit terms 2/15, net 45, this means that if by the fifteenth day the payment is made, the founders can take a discount of 2% of the $100,000, or $2,000. Thus payment to the vendor would be $98,000. If the payment is made any time after the fifteenth day, the full amount of the payment must be made and it must be made by the forty-fifth day.
If the discount is not taken, vendor financing becomes another form of debt financing and it too comes with a cost, although there is no stated interest rate. instead, there is an implicit interest rate that should be estimated before this form of debt financing is used, and it should be compared to alternative forms of debt financing. The implicit interest rate can be determined as follows using the previous illustration. By not taking the $2,00 discount, the founders are effectively borrowing $98,000 for thirty days. (Note that the firm is not borrowing $100,000.) The cost of borrowing is, therefore, $2,000/$98,000, or 2,04%. Although there are different methods for annualizing a thirty-day interest rate, to keep it simple, it can be multiplied by twelve. Thus the implicit interest cost is 24,48%.
- Jury, T. 2012
- Yescombe, E. R. 2002, p.31
- Fabozzi, F.J. 2016, p.101
- Brennan, M., Miksimovic, V., & Zechner, J. (1988). Vendor Financing, "The Journal of Finance", 43(5)
- Fabozzi, F.J. (2016). Entrepreneurial Finance and Accounting for High-Tech Companies, Mit Press
- Jury, T. (2012). Cash Flow Analysis and Forecasting: The Definitive Guide to Understanding and Using Published Cash Flow Data, John Wiley & Sons
- Yescombe, E. R. (2002). Principles of Project Finance, Elsevier
Author: Małgorzata Lasota