Vendor Financing Meaning Example How It Works

Vendor Financing Meaning

Types of Vendor Financing

#1 – Debt Financing

The borrower receives the products/services in debt financing at a sales price but with an agreed interest rate. The lender will earn this interest rate when the borrower pays the installments. If the borrower defaults, he is marked as a defaulter, and the loan is 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 dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more. The vendorVendorA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers.read more will also make a major decision in the 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

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Assume a manufacturing company A wants to procure raw materials from company B worth 10 Million. However, 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. Now company A can procure raw materials worth 10 million by paying 4 million upfront and the remaining 6 million in installments for 10% of the interest rate.

Importance

Vendor financing allows the business owners to purchase the required goods and services without approaching 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. Moreover, 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 cash for goods/services is not ideal for business, but making and generating sales is better. The vendor also earns interest on their financed amount. A small business firm often uses equity vendor financing, 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. On giving the finance to the business owner, the vendor receives a vendor note mentioning all the particulars of the transactions and 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 the vendor and borrowing company improves with better understanding.Borrower company provides shares to the vendor. In other words, it is offering partial ownership of the company.The transaction and the purchase of goods become attractive, thus bringing down price sensitivityPrice SensitivityPrice Sensitivity, also known and calculated by Price Elasticity of Demand, is a measure of change (in percentage term) in the demand of the product or service compared to the changes in the price. It is used widely in the business world to decide the pricing of a product or study consumer behavior.read more.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 that otherwise they cannot afford due to financial limitations.The borrower’s cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more is eased as they have fixed the outflow of payments for the next few years.Some vendors also provide leasing out options for borrower firms. This mitigates full payment and is very tax effective.

Limitations

The main reason a borrower company opts for vendor financing is due to the 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 of no value if the borrower company goes liquid and files for bankruptcy.Agent companies find the vendor to finance for the blue-chip companiesBlue-chip CompaniesBlue chip stocks are issued by companies possessing large market capitalization. Blue chip companies are market leaders. They provide good returns on stocks, offer dividends, and are considered safe investments.read more. For the service, these agents charge a commission that is a cost and expense for the vendor’s lending company. Sometimes they charge a commission to the borrowing company also.During a recession or when the economy is not performing well, companies usually choose to go for vendor financing to solve their liquidity problems and help their cause with working capital managementWorking Capital ManagementWorking Capital Management refers to the management of the capital that the company requires for financing its daily business operations. It is important for the company in order to maximize its operational efficiency, manage its short term liabilities and assets properly, avoiding the underutilization of the resources and avoiding the overtrading, etc.read more.The vendor charges higher interest than the usual banks for the borrower when they know the borrower has limited options to finance the sales.The default risk has to be taken by the vendor. If the borrower defaults and doesn’t make the payment, the vendor’s profitability will hit.

Conclusion

Vendor financing is an excellent feature in business that a borrowing (customer) company and lending (vendor) company can make use of. The borrower can benefit from it in case of a liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more crunch scenario, and the lender can lend to earn some extra cash through the interest rate charged on its customers. The vendor must be sure before availing of this option and 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 runs smoothly, this type of financing will only improve the relationship between a vendor and the borrower.