Professor Salima Paul is Professor of Credit Management at the University of Plymouth Business School. She has written widely for both academia and the credit community on trade credit management. Her work has also informed UK government policy: the Department for Business, Innovation and Skills (BIS), together with the Chartered Institute of Credit Management, the Forum of Private Business and Experian, published a brief guide entitled "Get Paid: guide to business owners and managers" based on findings from her research. She also holds the professorial chair within the Chartered Institute of Credit Management and in 2019 was voted ‘Woman of the Year’ at the Women in Credit Awards which champion women across the entire credit and financial services industry.
Trade credit, or business-to-business lending, has become a prominent part of the UK trading environment.
Recent data shows that at least 80 per cent of business-to-business transactions are on credit. Business customers expect goods and services to be offered on credit terms and sellers are incentivised (even pressurised) to grant such credit to remain competitive and close a deal. Trade credit has been a Cinderella subject, often neglected by academics and policy makers. The implications of its widespread use were little studied and understood. Professor Paul’s research has explored the importance of trade credit to Small and Medium-sized Enterprises (SMEs). Here she shares some insights into the problems that can arise for SMEs from late-payment in trade credit arrangements and identifies action business owners can take to manage the associated risks to their businesses.
Importance of credit
Trade credit offers advantages for both the seller and the buyer.
It gives buyers more purchasing power as they are effectively receiving goods and services temporarily for ‘free’. It can help a seller close a sale and, with trade credit arrangements in place, gain strategic advantage by increasing their market share and growing their customer base. By offering credit, the seller trusts the buyer to pay what is owed when it is due. The word ‘credit’ comes from the Latin word ‘credere’ meaning ‘believe/trust’ Sometimes this trust is misplaced. When customers do not pay on time problems can occur. Buyers paying late is the risky side of trade credit and one of the main causes of business failure today.
Small is beautiful (and increasingly important)
SMEs are particularly exposed in trade credit arrangements.
By virtue of their modest size, SMEs are generally less able to absorb potential cash flow problems when trade credit arrangements are not honoured. Operating on a smaller scale, there is often less formalisation in SMEs’ back-office systems; credit control and risk management processes may not be particularly robust. Many small (micro) owner-managed firms can focus too much attention on sales generation and fulfilment, neglecting activities such as risk assessment and customers’ credit worthiness. Firms can fail because their credit arrangements are managed either poorly, or too passively.
The irony, however, is that despite being particularly vulnerable in trade credit transactions, SMEs are an increasingly important part of the UK economy. They play a role as engines for growth and job creation. Of the almost six million private businesses in the UK in early 2020, 99.8% were SMEs with fewer than 250 employees. At that time, SMEs accounted for 52% of private sector turnover and 60% of all private sector jobs in the UK - a total of 16.6 million jobs.
Too little too late
My research has explored the importance of trade credit in the financing of SMEs and the problems that ensue when customers and clients stray beyond agreed payment terms.
SMEs often struggle to raise the finance necessary to keep their businesses afloat. This lack of finance, and the rate of SME insolvency, are often directly caused by customers paying late for goods and services. Government figures from December 2019 show that £44.6bn was owed to SMEs in late-payment. SME late-payment debt now averages £32,185, which equates in total to a substantial £26.3 billion. Eighty-five per cent of UK SMEs have experienced late-payment in the past two years. The Federation of Small Businesses recently found that over one third of SMEs had to seek external finance to cover financial deficits caused by late-payment. An SME’s ability to survive and grow is often jeopardised by late-payment and the debt interest charge could otherwise have been used for business investment.
My work exploring the seriousness of the situation of SME’s financing, and their exposure to late-payment, gained the attention of professional bodies such as the Association of Chartered Certified Accountants (ACCA) and policy makers at the Department for Business, Innovation and Skills (BIS). I was invited to work on ministerial public consultations and to evaluate the Trade Credit Enterprise Finance Guarantee scheme (TCEFG) as well. Our findings demonstrated that the scheme had very limited impact and delivered only modest results; more than half of SMEs were not even aware of it, and it was heavily focused on the construction sector.
Balance of power
We also found that trade credit was imperilled by the power imbalances between SMEs and larger firms.
Late-payment of trade debts is often reflected in the relative power positions of suppliers and customers (especially where customers are in a monopolistic or oligopolistic position). SMEs are at the mercy of larger organisations and endure more late payment than larger firms. They tend to have weaker trade credit policies and employ fewer staff to deal with trade credit management.
Both regulatory measures and internal management regimes had failed to mitigate the risks for UK SMEs extending trade credit. We urged policy makers to pursue a more proactive regulatory approach to tackle the payment culture in the UK and improve this power imbalance. Our research findings prompted the government to close the TCEFG scheme in 2015.
The government responded by announcing a range of proposals to support the development of alternative sources of finance to SMEs outside of TCEFG. These included prompt payment within the public sector supply chains, incentivising fair and transparent payment practice, strengthening the prompt payment code and promoting sector-based approaches to the development of advice and codes of best practice.
Our research prompted new thinking across the industry and amongst policy makers on how the challenges presented by trade credit might be mitigated through business practice and better UK policy and regulation.
Credit where credit is due
With UK businesses having to deal with the economic impact of the Covid-19 pandemic, and the changes following the UK’s departure from the European Union, there will be significant challenges ahead.
The exposure of SMEs (and of the wider economy) to these trade credit risks is likely to increase. Businesses, especially small ones, may have to offer even more generous credit terms to secure deals, further increasing their risk exposure. We know small businesses bear the brunt of the credit squeeze in times of financial pressure. However, it is important to emphasise that there are actions management can take to minimise their businesses’ vulnerability.
It is good practice for employees with credit management expertise to work alongside salespeople on a customer’s credit risk assessment and on the negotiation of credit terms. There should also be clear and established credit policies to follow, assessing who is receiving the credit and how capable they are of paying it back.
It is important for SMEs to ensure that they are managing their working capital closely. Poor management of working capital results in late-payment and default. It is often the primary cause of small business failure as it leaves businesses with insufficient liquidity. Businesses, especially small ones, would do well to focus more time and resources on this issue and implement more effective credit management. Improving the management of working capital makes businesses more resilient.
Each firm should have a clearly formulated and documented credit policy that is understood and adopted by everyone involved in the process of giving credit to customers. It needs to determine the company’s actual practice. Enforcing credit terms can be a problem, especially for small firms. One way to manage this risk may be to obtain credit insurance.
Firms need robust and reliable processes to assess risk and decide whether to extend credit. Knowing and understanding the customer base is vital to good decision-making. Larger firms are more likely to categorise customer risk and implement better credit control and payment methods. They are also more likely to receive prompt-payment from the customer base. Firms that address credit management proactively, evaluating credit risks and establishing payment terms and methods, spend less time and resources on collecting payments and resolving disputed billing.
Counting the cost
Conversely, companies whose credit terms are ad hoc responses to customer demands, spend more time negotiating credit terms which increases transaction costs.
We know that time spent chasing late payers costs the economy millions of wasted working hours. Poor management of trade credit is expensive. A seller is essentially offering the buyer an interest free loan; if sellers need to borrow to cover that loan, they will invariably be paying interest on such borrowing, hence increasing their financial costs and decreasing their profit margins.
The South West’s small business sector is dominated by micro-businesses employing up to nine people. It is the fastest growing business sector by size in the region. My suspicion is that many of these businesses could manage their trade credit arrangements more robustly. In the uncertain times ahead, this is one of the ways business leaders can make their firms more resilient.
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