Vendor Financing Meaning
Vendor Financing, also known as trade credit, is lending of money by the vendor to its customers who in turn use the money to buy products/services from the same vendor. Customer need not pay for the products upfront when they are buying the goods but after the sale of the product. The vendor gives a line of credit to its customer based on their goodwill and rapport to pay for the products after a certain period of time or over a period of time.
Types of Vendor Financing
#1 – Debt Financing
In debt financing, the borrower receives the products/services at sales price but with an agreed interest rate. The lender will be earning this interest rate as an when the borrower pays the installments. If the borrower defaults, he is marked as defaulter and loan are written down under bad debts.
#2 – Equity Financing
In equity financing, the borrower receives the products/services in exchange for the agreed number of the stocks. Since the vendor is paid in shares (upfront or at a particular time), the borrower need not pay any cash for the transaction to the supplier. The vendor becomes the shareholder and will start receiving dividends. The vendor will also make a major decision in borrowing company as he is also the owner (to the extent of the number of shares held) of the borrower company.
Example of Vendor Financing
Assume a manufacturing company A wants to procure raw materials from company B for worth 10 Million. Company A can only pay 4 million to company B due to its liquidity crunch. In this case company B agrees to give raw materials worth 10 Million after taking 4 million. For the remaining 6 million outstanding amount, company B charges the company a nominal interest rate of 10% for a certain period of time. Now company A can procure raw materials worth 10 million by paying 4 million upfront and the remaining 6 million in instalments for 10% of the interest rate.
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Importance
Vendor financing allows the business owners to purchase the required goods and services without being able to approach the financial institution for funds. This will help them save a good interest on the borrowed amount. Sometimes banks also ask for collateral to give loans which can be mitigated if opted for vendor financing. The business owners can use the credit limit given by banks for other ventures (expansion, machinery, supply chain, resource). This will, in turn, boost the revenue. The crucial point is that it establishes a relation between a borrower and the vendor.
Not receiving the cash for the sale of goods/services is not ideal in terms of business but it is better not doing sales and generating sales at all. The vendor also earns interest on their financed amount. For a firm doing small business, it often uses equity vendor financing which is also sometimes referred to as inventory financing. Vendor on giving the finance to business owner receives a vendor note mentioning all the particulars of the transactions along with the terms.
Benefits
- The vendor increases his sales by a significant amount.
- The vendor earns interest on the outstanding amount with the borrower. This interest is usually higher than other financial institutions.
- The relationship with vendor and borrowing company improves with better understanding.
- Borrower Company provides shares to the vendor, in other words, it is offering the partial ownership of the company.
- The transaction and the purchase of goods become attractive thus bringing down price sensitivity.
- The procurement for the borrowing company becomes smooth and need not go in search of the lender to finance the transaction.
- The purchaser can buy goods which otherwise they cannot afford due to financial limitations.
- The cash flow of borrower is eased as they have fixed outflow of payments for the next years.
- Some vendors also provide leasing out options for borrower firms, this mitigates full payment and is very much tax effective.
Limitations
- The main reason a borrower company opts for vendor financing is due to liquidity cash crunch. Providing loans to such firms can lead to default in payment and the loan being counted under bad debt in the books of a lending company (vendor)
- The shares received by the vendor in case of equity financing can be no value if the borrower company goes liquid and files for bankruptcy.
- There are agent companies who find the vendor to finance for the blue-chip companies, for the service these agent charge a commission which is cost and expense for the lending company which in this is the vendor. Sometimes they also charge a commission to the borrowing company also.
- During a recession or when the economy is not performing well, companies usually chose the option to go for vendor financing to solve their liquidity problems and help their cause with working capital management.
- Vendor charges higher interest than the usual banks for the borrower when they get to know the borrower has limited option to finance for the sales.
- The default risk has to be taken by the vendor, if borrower defaults and doesn’t make the payment, the vendor’s profitability will take a hit.
Conclusion
Vendor financing is an excellent feature in business which a borrowing (customer) company and lending (vendor) company can make use of. The borrower can benefit from it in case of a liquidity crunch scenario and the lender can lend to earn some extra cash through the interest rate charged on its customers. The vendor has to be sure before going to avail this option and should take the risk if a borrower defaults on the payment or liquidates in a worst-case scenario. Thus, it is both a boon and a ban in the field of business which should be executed with utmost caution and only upon requirement under certain conditions. If the transaction is running smoothly, this type of financing will only improve the relationship between a vendor and the borrower.
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