Trade credit: Understanding its importance

Trade credit: Understanding its importance

Paul, Salima Y

In the second article in this important series, Dr. Salima Y. Paul analyses her in-depth research into the use of credit in today’s marketplace, explaining the vital role that it plays in all areas of UK business

Importance of trade credit

In the UK economy where at least 80% of business to business transactions take place on credit, giving and getting credit is important for all firms but especially so for small ones since they do not have the same borrowing power as the large companies, neither can they generate cash in the same way. Therefore, while their survival depends on getting credit, it depends equally on giving credit to be competitive. In the UK, it is found that the stocks and flows of trade credit are typically twice the size of those for bank credits111; while as for the US, it is reported that trade credit is one of the most important forms of finance, far exceeding the business lending of the entire banking systemi2′. In our previous article, we reported that in a recent UK survey trade credit constituted an average of 37% of companies’ total assets in the balance sheet. This has been increasing over time to fill a finance gap caused by imperfections in the capital market.

Our survey shows that 87% of firms in the sample sell between 80% and 100% of their goods/services on credit and one third of them grant trade credit on every business transaction. Moreover, 81% of the companies in the sample grant trade credit to over 80% of their customers. So trade credit supply is very popular amongst our respondents.

On the other hand, the average quarterly volume of credit sales for our respondents is £6.7m. But the difference between companies’ credit sales is great; this figure varies between £250 and £120m. Nearly 75% of the firms have credit sales of a volume between £0.1 m and £5m; 8.5% have average credit sales of £54m. Half of the firms with high credit sales are in the manufacturing sector and a quarter are in the business and financial services sector.

Further analysis has been undertaken between firm size and the volume of credit sales. The results show a strong correlation between the two. Firms’ size, based on the number of employees and turnover, has an impact on the volume of sales it grants. More explanation will be given when we study factors affecting trade credit.

Many studies address the reasons for this increase in and granting of trade credit. The main motives identified in the literature include finance, marketing, investment, information, efficiency, and competitiveness. Some’3′ argue that the increase in credit sales has become necessary for companies to remain competitive and that it contributes to promoting growth in sales. Others’4′ identified the generic forces behind the trade credit offer, examined theoretical explanations, compared them with what happened in practice and found strong links between trade credit motives and competitiveness, pricing, investment and financing. Others still[5] have noted that some small companies use trade credit as a mean of attracting new and large customers, signalling supplier commitment and showing their financial health. Paul and Wilson[6] (2006) found that some firms in their sample used trade credit to signal their confidence in the quality of their product as they were prepared to give buyers sufficient time to inspect the goods and services before paying for them. Whatever the motives for trade credit popularity, first of all and before any analysis, it is very important to understand its nature and what it involves.

Understanding trade credit

Sellers can exchange their products/services for cash, but if they choose to allow a time lapse between the transaction of delivering goods and services and the receipt of cash they are allowing the buyers to delay payment and are therefore offering credit. So, trade credit is offered by non-financial firms that are in business not to provide finance to their customers but to sell them goods/ services. Although there are many different definitions of trade credit, they all agree on the fact that it is the deferring of payment to an agreed date in the future. Trade credit supply thus creates a current asset in the firm’s balance sheet: “trade debtors”.

On the other hand, few question the economic importance of trade credit as a source of finance when firms use it to fund their purchases. Theory posits that imperfections, in product and capital markets, cause financial institutions to limit the credit they offer to businesses. Consequently, firms look for alternatives to finance their stock and very often turn to trade credit. So, as well as offering trade credit, firms require it and therefore trade credit is two-sided. The demand for trade credit creates a current liability in the balance sheet: “trade creditors”. Thus, the difference between trade debtor and trade creditors constitutes the firm’s net credit position. If trade debtors are greater than trade creditors, the company is a net provider of trade credit and vice versa. Both elements may be monitored as part of trade credit management. Furthermore, trade credit management is part of the overall working capital and can affect the company’s profitability, liquidity and solvency.

The importance of trade credit demand is reflected in our findings. The percentage of total purchases on credit is mirrored by the supply of trade credit: 93% of the respondents purchase over 80% of their goods/services on credit. As many as 86% require between 90% and 100% of their purchases on credit with a Mean of over 94% (60% get 100% of their purchases on credit). So our firms demand for trade credit is as much as (and in some cases more than) their supply of it. Only three companies out of 355 in the total sample buy their goods either cash or on terms other than trade credit.

If trade credit supply, represented by “accounts receivable”, is a function of credit sales, trade credit demand, which is the amount of “accounts payable” in the balance sheet, is a function of credit purchases. Trade credit is therefore two-sided and both elements may be monitored as part of overall working capital management. Demand for trade credit is equally important, especially if trade credit is construed as a source of finance. So, when choosing between alternative sources of funds, trade credit availability and cost will be amongst the deciding factors.

Because trade credit is a potential source of finance, financial managers may have to consider its position in the “pecking order” when choosing between alternative sources of funds if they are to minimise the cost of finance. Some firms may switch from bank credit to trade credit to finance their operations when the price of a loan rises above the cost of trade credit[7]. Others may have borrowing constraints, limiting their capacity to acquire external funds and thus substitute and/or complement, whenever they can, between/with bank and trade credit. For most, the high transaction costs involved in acquiring funds from financial institutions are an incentive to choose trade credit as a source of finance, whenever possible.

As expected, 61% of firms in our sample, very often or always consider trade credit a cheaper way of financing their purchases than obtaining finance elsewhere; while only 8% rarely or never see trade credit as a cheaper way of finance with a Mean of 3%. Furthermore, 51% see trade credit as an alternative source of finance with a third of them claiming to use it to fill gaps when other sources of finance are rationed. Fewer than 10% of them strongly disagreed or disagreed that the important reason for trade credit demand is an alternative source of finance when others are rationed.

Fewer than 10% of our respondents disagreed or strongly disagreed that an important reason for trade credit demand was as an alternative source of finance. Moreover, over 44% claimed that trade credit demand might be determined by the company’s credit rating, only 10% thought that credit rating had nothing to do with trade credit demand while the rest (45%) were neutral.

We also asked the respondents whether their perception of the trade credit decision was as a financial decision, a marketing decision or a customer relation decision and found that their views were much divided. The perception that trade credit granting behaviour was a financial decision was prevalent within firms in the sample as over two thirds (77%) saw trade credit granting as mainly or predominantly a financial decision, while 31% of firms saw credit granting as a customer relation decision and only 18% perceived it as a marketing decision. These findings were in line with our earlier claim that firms considered trade credit as a tool that helped them finance their day-to-day operations.

An analysis of the break-down of this perception was then looked at within different sectors. It is interesting to note that different sectors had different perceptions: we found that around a third of firms in the transport/communication and the wholesale distribution sectors perceived trade credit granting as a marketing decision (33% and 33.3% respectively) or a customer relations decision (29% and 53% respectively). This reflects the way trade credit is used according to the specific sector’s needs for finance, marketing and customer relations.

The extent of the use of trade credit may make it take a high place in the pecking order chain. It is found that trade credit is often widely used by small firms suffering rationing[8] and during downturns; banks deny loans to weak, low quality borrowers[9] in favour of strong borrowers. Therefore, suppliers of trade credit are often seen to be acting as facilitators. Offered in this way, trade credit goes towards the top of the pecking order where firms invest in their customers in the hope of gaining and/or maintaining long-term customer relationships and loyalty. In addition, high transaction costs from financial institutions make trade credit much more attractive, especially when the supplier has access to financial markets at a rate not available to its customers[10].

Furthermore, when choosing between different sources of finance, trade credit may be higher on the list because the separation of the exchange of goods from that of money not only reduces the frequency of payments but also creates cost reductions and operating efficiencies; the costs of employees who have to monitor cash are reduced as is the risk of monetary theft. However, financially constrained firms tend to rely more on trade credit regardless of its cost and some increase their use of trade credit even when it is an unattractive and/or expensive substitute for bank credit. This applies especially to companies that have significant working capital tied up in the production process, such as manufacturing firms, and which have to wait a long period before any revenue is received. Such manufacturing companies tend to depend more on external finance to see them through this process. If they then sell on credit, this further delays the cash coming in; and if their customers delay payments, they may even encounter financial distress and limit investment to survive. This is even more the case for small manufacturing than other firms since they tend to be more dependent on financial institutions and without alternative financing, some are forced to limit desired future investment or even current production[11]. Thus, they need alternative financing and may demand more trade credit from their suppliers. Furthermore, some small firms’ survival depends on whether they get trade credit or not and the terms and conditions of the credit offered may “make them or break them.”

The net credit (difference between debtors and creditors) could be used as a means of comparing the cost of giving credit with the benefit of obtaining it. If companies operate in a competitive environment where credit industry norms have to be followed in order to sell, then they must also find the best way to finance the credit offered. Their choice of the source of funds to finance their customers’ stock will depend on their access to the money market. But whichever source they use, they must have an effective financing credit policy with its main aim being cost reduction and improvement of credit risk management. The two sides of trade credit can be used strategically where companies examine their net credit position to assess whether trade debts can be financed by trade credit if they get longer than they give. However, what measures net credit is not so much the length alone but rather the value of the debtors compared with the value of the creditors in the balance sheet. Our analysis of net credit shows that firms with good credit scores are more likely to be net providers of credit as they can (relatively) easily access funds and thus grant more credit (and for longer) than they get. However those that deal with a large number of suppliers are more likely to be net credit seekers since these firms have high transaction costs and thus may be less willing to extend credit more than necessary. Moreover, when firms deal with a large number of suppliers, they may not be so familiar with products’ quality and thus demand credit that gives them time for inspection.

[1] Wilson and Summers (1998)

[2] Lee and Stowe (1993)

[3] As reported in Copeland and Khoury (1980)

[4] Pike and Cheng (19961)

[5] Petersen and Rajan 11997) and Summers and Wilson (2000)

[6] Paul and Wilson (2006) found evidence for asymmetric information (this will be explained in subsequent articles).

[7] Atanasova and Wilson (2003)

[8] Nilsen and Gerzensee (1999)

[9] Nilsen and Gerzensee (1999)

[10] Pike, Cheng and Chadwick (1998)

[11] Nelson and Gerzensee (1999).

Dr Paul’s series continues next month with an examination of the theories behind trade credit.

Copyright Institute of Credit Management Ltd. Mar 2007

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