The problems SMEs face when trying to gain access to working capital is a common theme on this blog. But one area that we’ve not discussed in detail before is the growing trend for business-to-business lending in the form of trade credit. British firms currently owe each other a staggering £75 billion in unpaid bills, a sum that has been fuelled in recent years by the ongoing absence of bank funding.
This lack of conventional lending has resulted in a significant boost to alternative finance – short-term lenders like us, Boost Capital, invoice discounting, even peer-to-peer lenders. But trade credit is another area that has experienced a big growth in interest, involving, as it does, non-financial firms granting credit to their customers by allowing them goods or services without immediate cash payment. Such arrangements have long been popular with smaller businesses, and many SMEs fill financial gaps with informal credit of this type.
But trade credit is now 20 per cent greater than bank lending to businesses in Britain, according to new research from the Credit Management Research Centre (CMRC) and supplier finance network Taulia. A vast amount of money is tied up in these arrangements at any one time. The CMRC points out that if companies just paid suppliers five days faster a whopping £29 billion worth of working capital would be released, £7.7 billion of it going specifically to SMEs. British firms are also far more likely to use trade credit to prop up their enterprise than businesses elsewhere. About six out of ten UK companies used trade credit in the last six months, according to a study from accountancy firm Mazar’s, twice the European average of 32 per cent.
The attractions for small companies are clear. Such arrangements are cheap, if not completely free. This type of credit is self-liquidating, in so far as most supplies bought on credit are typically for inventories that will themselves later provide the funds needed to pay the supplier. And, again, when times are tough and conventional sources of capital are restricted, trade credit is often easily arranged, and can provide a cushion for businesses that would otherwise struggle.
However, the reality is that such practices can put many firms under a great deal of strain, with the risk of insolvency being a distinct possibility for some of those businesses left out of pocket for longer. Put simply, one firm’s trade credit can turn into another’s late payment, and we’ve talked before about the damage sluggish settlement of bills can have on SMEs. Which isn’t to say that trade credit is necessarily a bad thing. It’s how it’s executed that matters, along with the credit management practices within a firm offering it. The Association of Chartered Certified Accountants (ACCA) has analysed trade credit behaviour in countries across the globe, and it revealed some typical attitudes on the part of participating small firms:
- Business owners often rely on trust, instinct, personal relationships or the reputation of a company when setting up trade credit agreements with other firms.
- Not enough enterprises seek out and scrutinise a customer’s financial statements and other relevant public information before making a decision about whether to extend them credit.
- Small companies are more likely to give trade credit without checking a customer’s financial history if they are also a smaller business.
Trust and gut instinct are important parts of business life, but firms are unwise not to do a more thorough background check on a company before extending it favourable credit terms. There are a number of resources that business owners can use when conducting this kind of research:
- Companies House filings. Accounts are filed at the company register containing important financial information, and possibly giving an idea of the state of a business’s health. However, how much detail is available in these documents will depend on the size of the firm – the smallest only have to file abbreviated accounts. But a lot can also be inferred from how promptly a company files. Late filing or unavailable information could be a warning sign that all is not well with a company’s operation.
- Credit rating agencies. Businesses can buy status reports from credit professionals who will have access to payment data from company suppliers, and official reports, as well as mining data found online and assessing financial statements. A full credit check is wise for customers that account for a lot of sales, whereas smaller ones may only require a quick and cursory scan.
- County court judgements. It’s possible to search online for a small cost to see if a business has a CCJ outstanding against it for debt. This may help to determine whether they’ve paid their bills in the past, or been sued for non-delivery of goods bought.
Since so many businesses are still rather lax in their approach to checking customers’ backgrounds, industry heavyweights, including ACCA and the Chartered Institute of Purchasing and Supply (CIPS), have joined together to form a Trade Credit Improvement Consortium. This body has the stated mission to encourage buyers and suppliers to improve their trade practices, and it is currently devising a toolkit to help businesses achieve this. Firms can sign a trade credit pledge at http://securetherecovery.co.uk/, vowing to employ best practice in their dealings with other firms. Signatories will also receive the latest academic research on the trade credit gap, plus all future information and guidance from the group.
It’s sensible for cash-strapped firms not to become too dependent on long trade credit agreements. Credit terms often vary, and businesses that aren’t careful may end up paying more for inventory if suppliers use differential pricing for trade credit deals. SMEs should investigate all the financing options available to them, since many more have emerged during the economic downturn, and some business owners may not realise all of the funding sources available. Trade credit certainly isn’t going away, and many firms depend on their peers as one source of working capital to fund day-to-day operations. But they must also be careful not to extend any of their financial problems to fellow businesses. And those offering trade credit must keep on top of their processes and credit management practices to ensure that everyone in the chain is sufficiently secure.
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