Vendor Financing

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 debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read more.

#2 – Equity Financing

In equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more, 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 dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.read more. 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

Vendor Financing

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For eg:
Source: Vendor Financing (wallstreetmojo.com)

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 rateNominal Interest RateNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans.read more 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.

Importance

Vendor financing allows the business owners to purchase the required goods and services without being able to approach the financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more 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 financingInventory FinancingInventory financing is a short-term loan or a line of credit that keeps revolving after a pre-decided time period and is used to finance the company's inventory, with the purchased inventory acting as collateral for the loan. If the firm fails to repay the loan, the lender has full authority to seize and sell the inventory in order to recover the lent capital.read more. Vendor on giving the finance to business owner receives a vendor note mentioning all the particulars of the transactions along with the terms.

Benefits

Limitations

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 liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more 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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This has been a Guide to Vendor Financing and its Meaning. Here we discuss the types of vendor financing along with example, benefits, importance and limitations. You can learn more about from the following articles –