Salima Paul and Rebecca Boden
At one level, trade credit is extraordinarily simple – it occurs when suppliers of goods and services permit customers to defer payment for a period of time after delivery. This simple concept belies a complex reality; trade credit consists of an extremely heterogeneous set of business-to-business financial arrangements arising out of a complex network of relationships.
Trade credit is an essential element of the cash conversion cycle and thus plays an important role in financing operations. On average, trade credit exceeds the primary money supply by a factor of two (Wilson, 2008). Its use in the UK is significant: around 80% of business-to-business transactions are on credit and it constitutes about 37% of total business assets (Paul and Wilson, 2006). In sum, trade credit is part of the business financing system, yet trade credit exposes suppliers to significant risk if customers pay late or not at all. SMEs, which appear to be particularly reliant on trade credit to win and sustain their customers bases, may be particularly vulnerable here. Given the preponderance of SMEs in the UK and their role as an engine for growth and job creation, the macroeconomic significance of this risk is considerable.
In the context of continuing UK economic difficulties, trade credit is likely to become an even bigger issue for the survival and prosperity of SMEs, especially with regard to late payment. The rationing of financial credit inherent to the current economic climate highlights the importance of trade credit; in times of recession ‘small businesses bear the brunt of the credit squeeze’ and ‘there is a clear relationship between late payment and the rate of insolvency and bankruptcy’ (Wilson 2008:7-8).
During the last recession late payment of trade debts severely adversely affected SMEs and many of the firms that failed were not necessarily unprofitable or inefficient, but were ruined by the liquidity problems that are often related to late payment (Paul, 2010). In the current period of financial distress, it is reported that 10% of SMEs are collapsing because of late payment and default (Federation of Small Businesses, The Times 14 April 2008). And as SMEs are struggling to survive and compete, they may have to offer even more generous credit terms to win business, thus increasing their risk exposure further.
The Forum of Private Business asserts that ‘it seems to be almost endemic that the SMEs will have to wait for large customers to pay them’ and reports that 88% of small firms claim that the worst payers are large businesses. It is reported that ‘SMEs are owed twice as much trade credit as they themselves owe to large businesses. The balance is an interest-free loan of £20 billion, which SMEs grant -or rather, are forced to grant- to larger businesses’ (EU website). Larger firms tend to be more cash-rich, yet these tend to be the ones that benefit from the cheap or free loans inherent to trade credit.
Theories on trade credit (for a summary see Paul and Boden 2008) suggest that, despite the risk of default, trade credit offers a number of strategic advantages to both customers and suppliers, principally in terms of signalling/market information, mitigation of finance costs and the building of strong supply chains. Late payment of trade debts constitutes the failure of arrangements that should have been constructed to realise these strategic advantages. Despite the fact that, in the UK, late payment persists as an intractable and increasing problem, surprisingly little is known about why and how these heterogeneous relationships, negotiated bilaterally between customers and suppliers, fail. This formed the focus of a project that we undertook, with the financial assistance of the ACCA.
This was a qualitative piece of work. In contrast to the overwhelming majority of trade credit research which seeks to quantify the problem, we were interested in talking to suppliers and customers in order to discern why trade credit relationships were failing. We interviewed 40 firms in total. We now outline the main elements of our findings.
Underlying principles
‘Good’ trade credit relationships, where both parties achieve synergistic mutual benefit, were deemed to be underpinned by equity, ethical business conduct and sustainability. That is, sound relationships were deemed to be those where there was no abuse of power by one party, where all behaved in an ethical manner and where the overall objective was sustainable business and relationships.
External environment
The external environment in which firms operated was found to affect their capacity to build and sustain such relationships. The sector in which the firms were situated was a key factor; the characteristics and practices of particular sectors set the framework for these business relationships. Regulatory devices designed to combat late payment, such as the statutory right to claim interest on late payments, were also part of the environment. However, we discovered that, for the most part, such measures were only deployed when the relationship had failed, payment was late and there was little supplier interest in trading with that customer again. Finally, at present, the current economic climate in the UK has had a profound adverse impact on how trade relationships work.
Being a good supplier
How firms organised their credit function internally and their attitudes/behaviours towards trade credit were absolutely central to the success of their arrangements. Firms which took a strategic approach, seeing trade credit as an important business opportunity rather than a simple debt-collecting function, reported far fewer late payment problems than their counterparts. These strategically-inclined firms had taken steps to organise themselves carefully. The management of credit was ‘mainstreamed’ within the firm: credit managers/controllers were part of key decision-making and their colleagues understood and respected the value of their work. These firms tended to have clearly articulated credit policies and had arranged their affairs such that these were enforceable. These firms had well-trained and experienced credit management staff who exhibited a clear commitment to their work and an understanding of their role in the business process.
Being a good customer
Being a good customer, in terms of negotiating equitable and ethical arrangements and sticking to them, can yield significant strategic advantage. However, we found that even strategically-oriented firms tended to have less of an appreciation of the value to the firm of being a ‘good customer’ and this had consequential impacts on the attention paid to prompt payment. However, they still tended to be better-payers than their less-strategic counterparts.
Not all of these firms met the principles of equity and ethical behaviour: some were fairly aggressive, using their organisational ability and clear strategic goals to maximise their own financial position, whatever the cost to their business partners, often exploiting weaknesses found on the other side. These firms experienced fewer late payment issues, but were not good-payers themselves.
A range of intra-firm characteristics associated with the mitigation of late payment risk and being ‘good payers’ were identified. These positive firm characteristics then played themselves out successfully in relationships with partners in their supply chains. Well-organised firms (whether customers or suppliers) with a strategic orientation were able to negotiate and control credit very effectively, reducing risks and generating strategic advantage. The unethical and inequitable behaviour of large firms towards SMEs was, in some instances, deemed problematic. However, there was confidence amongst respondents that, if SMEs went into these relationships well-organised and resourced with the right kinds of skills and attitudes, then adverse consequences could be averted.
Conclusion
SME lobby groups consistently maintain that the root cause of most of those firms’ problems is their late-paying larger customers. The policy and professional response to this risk has been to enact legislation increasing disclosure of large companies’ payment trends and enabling firms to charge punitive interest on late payers. There are also a variety of self-regulatory measures such as ‘prompt payment codes.’ Emphasis has been given to training for SMEs on credit management. These measures are useful tools for combating late payment but, on their own, have proved largely ineffective.
There is no magic bullet that will solve the late payment problem, nor any particularly easy answer. We conclude that it might be more productive to see trade credit relationships as just that – relationships – which have to be organised, managed and nurtured. Our research suggests that the best way of addressing trade credit failures is by exploring the ways in which both customers and suppliers can be encouraged, educated, trained, incentivised and organised into better relationships that mitigate the late payment risk.
There is no single solution, no template for all business to follow, because businesses are so different. Moreover, imposing a single model might prevent some firms from realising some of the strategic benefits already identified in our research. There is an important new role here for the accounting profession to act as champions for better trade credit relationships by helping their clients or firms realise the strategic opportunities that trade credit offers whilst mitigating the risk.
Dr Salima Paul, Senior Lecturer, UWE, Professor Rebecca Boden, Director, Institute for Social Innovation