University of Bradford
Bradford BD9 4JL, U.K.
Few would question the economic significance of trade credit as a source of business funds. A recent survey of owner-managed businesses, conducted by the CMRG has demonstrated the extent to which firms use trade credit to finance their purchases (Wilson, Watson and Summers, 1995). Trade credit is especially important for smaller and growing businesses. The reasons why businesses use trade credit are the subject of some debate; empirical evidence that addresses this question will have a particular bearing on the credit rationing debate. Though trade credit is an important source of funds for small businesses, relatively little effort has gone into understanding the reasons why businesses use it. This paper suggests that trade credit is often used as a premium source of short-term finance for firms that are having difficulty raising institutional funds.
Theoreticians in corporate finance and economics have attempted to explain and understand firm level decision making with regard to the use of credit. Two main theories have been put forward, Financing Theory and Transaction Costs Theory.
Financing theory suggests that credit market imperfections cause the
traditional sources of credit, financial institutions, to ration business
credit so businesses have to seek other sources of finance, i.e., their
suppliers, potentially at higher implicit interest rates depending on the
credit terms offered. The reasons for rationing centre on the information
asymmetry between lenders and borrowers; lenders have insufficient information
to assess the risks of lending to certain business borrowers and are unable
or unwilling to incur the costs involved in setting an appropriate interest
premium for all classes of customer risk. Alternatively lenders may
attach conditions to credit causing the borrower to bear some risk (e.g.,
providing a house as security) on the basis that the borrower has more
information on their own default risk and their response is therefore a
signal on the risk of the loan.
Transaction Costs Theory suggest that firms use trade credit to obtain efficiencies in cash management. If trade credit were not available firms would either have to hold large cash balances to pay for supplies or perhaps arrange frequent small loans, which would incur fixed costs.
A postal survey of small companies in the UK was conducted during 1996. This generated detailed information on 343 respondents covering areas such as products, markets, financing, credit policy and credit management practices, bank relationships and working capital management. The survey data was supplemented with several years accounting, risk assessment and payment history information supplied by Dun & Bradstreet. A number of variables relating to the firms usage and demand for trade credit were measured. This enabled the estimation of a series of demand models using multivariate techniques for continuous and limited dependent variables which yielded insights into firm level decisions and behavior relating to the use of trade credit and the late payment of commercial debt.
There was some support for both the transactions and financing demand theories. The findings of this study suggest that the financing demand is dominant and is the major factor determining the extent of trade credit usage and late payment behavior. In summary, taking the multivariate and other evidence into consideration, the profile of smaller firms who pay late suggests that these are firms trading in competitive markets, often growing and export oriented; who are having difficulty in raising external finance from the banking sector. They appear to have reached a credit limit from the banking sector, based on perceived business and financial risk, and are having difficulty managing short-term finance. Their cash-flow is further affected by customer demands for long credit periods; liquidity is relatively low and they choose to finance their operations via extended trade credit at a premium rate of interest (foregone discounts and interest penalties). Further research is underway on the relationships between small firms and the banking sector.
There are a number of policy implications from these findings. The first is related to the issue of legislation for 'statutory rights to interest' on late payments which has been mooted and vigorously debated throughout the EC. The other broader issue concerns the financing of the small business sector, small firm relationships with the banking sectors and the existence or otherwise of credit rationing. Our results suggest the existence of a finance gap and that attempts to control the payment behavior of those insufficiently capitalized to respond may not achieve the desired results.