The previous chapter has offered a variety of theories and conjecture about corporate practices, while the survey has provided an opportunity to generate any relevant evidence of the management practice of trade credit. This finding is consistent with the observation in the literature that there is variation in the way trade credit management is practiced.
This chapter will critically analyse how trade credit emerged and is used in the UK business. A large proportion of the transaction between business customers and supplier are credit based. The relationship and practice between buyers and suppliers will be examined using the following empirical data;
SOURCES OF SECONDARY DATA
TITLE
YEAR
GRAYDON/FORUM FOR PRIVATE BUSINESS
Payment Culture
2012
FEDERATION OF SMALL BUSINESSES
Late Payment Survey
2011
FEDERATION OF SMALL BUSINESSES
Voice of Small Business Members' Survey
2012
BCDR-SME FINANCE MONTIOR
SME Finance Monitor Report
2012/2011
INTRUM JUSTIA
European Payment Index
2012/2009
ACCA Publication
Getting Paid: Lessons for and from SMEs
2012
CMRC/EULER HEMRES
Credit Insurance Supports Companies' Profitable Growth
2006
4.2 TRADE CREDIT AND FINANCIAL CRISIS
One of the outstanding issues highlighted in the 2008/2009 financial crisis is the reduction in the capital required by financial institutions. This led to a significant increase in financial risk in the financial sector; as it is illustrated by the subprime mortgage crisis. The devastating impact of the financial crisis caused the reluctance of financial institutions to offer credit to UK SME, next to the fact that small firms suffer more from a declining demand resulting in lower sales, leading to serious cash flow problems. The consequences of the financial crisis have prompted the financial authorities to reconsider the international framework regulating the banking system (Dun & Bradstreet, 2010). In this accord, the Basel Committee on Banking Supervision has issued a series of conclusive document with the aim of reviewing the existing guidelines on financial market.
Basel III is the global framework governing the regulation of bank capital liquidity and leverage agreed in the aftermath of the global financial crisis of 2008/2009 (ACCA, 2012). The focus is not primarily about a bank's balance sheet, but the sum of its risk-weighted assets. The Basel III is often described as a recipe for mitigating and perhaps even avoiding future financial crises, its effects on lending to small businesses are generally expected to be disproportionately negative.
4.2.1 TREND OF BASEL III ON BANK FINANCE and TRADE FINANCE
The core of the Basel III reform suggests that;
The rates of capital equipment of banks have increased from 4.0% to 6.0%. This change emphasis on more capital to reinforce the capital against losses. The stricter requirement with regards to regularly capital can lead to increase financing cost.
The required ratio of equity to weighted assets will rise from 2.0% to 4.5%. The risk-weighted assets will be considered as the benchmark ratio, replacing the Tier 1capital ratio.
Finally the new rules have introduced a capital conversation buffer that will have to be above 2.5% and be met with common equity (when the bank capital ratio falls below 7.0%), the financial institution will be authorised to draw upon this capital buffer by curtailing the distribution of dividend and bonuses.
Many of the same features that comprise the framework hostile to SME lending also make it obvious to true risk in trading. The implication of this rule on trade finance has shown that the cost of financing trade will significantly increase. According to the Dun & Bradstreet special report 2010, they believe that letter of credit and trade letter of credit will become more expensive as exporters are likely to switch to less expensive trade financing instrument (Dun & Bradstreet, 2010). The Basel III has caused tighter access to trade credit as a result of increase in the capital conversion force might significantly have a negative effect on world trade.
42.2 Impact of BASEL III Risk Weighting On SME
The provision of the Basel III reveals that the capital requirement is sensitive's to risk. The main modification is that retail risk rating (75%) can be used to weight SME loans provide the bank portfolio is diverse and the bank loan to an SME borrower is less than
However, the OCED reports point out that the BASEL III weighting system favours many large enterprises over small companies. According to the report, larger firms come with good external credit rating are assigned a 20 % risk weight whereas SME that are unrated have a risk weighting of 100% or 75% (OECD, 2012). Under Basel III, the difference in core Tier 1 capital the bank needs to hold against their loans is remarkable: 7% of the loan for SME with 100% risk weighting as opposed to 1.4% (7% x 20%) for a large company with an AAA rating (OECD, 2012).
Moreover, as the OECD points out, there may be ways to mitigate those potential harmful side-effects of banking reform. That is already happening: as the Bank of England and the European Central Bank have kept the cost of borrowing so low, interest rates have often remained more affordable than prior to the crisis, even if SMEs have had to pay higher costs.
Government guarantee schemes may help too. Banks calculating their financial strength using risk-weighted assets will have to worry less about loans to SMEs that are underwritten by the state
4.3 External Finance and Trade Credit
Whilst access to finance is important, around half of SMEs do not use formal sources of external finance, instead relying on trade credit from their suppliers or retained earnings. Of the half of SMEs who use at least one form of external finance most commonly use bank funding; either loans, credit cards or overdrafts. A minority use equity finance, from either venture capitalists or business angels. SMEs do not generally access capital or bond markets due to their size and the small amounts of money they are seeking.
Clearly the Basel III rule has made it difficult for small business to access bank loan and trade finance with increasing the capital requirement for banks will mean higher inertest rates. Surprisingly, the SME Monitor surveys 2011 reported that SME rely more on bank finance compared to trade credit and retained earnings. Their findings show that there appears to be an increase in the number of SME offering bank credit over time, it does suggest that firms accommodate individual buyers by extending the credit. In considering the study, it can be assumed that there is an overlapping use of personal bank overdraft with business use of the business owner may have a good relationship with the bank. In that context, the Basel III reforms look much less threatening to SMEs. If those reforms are successful in their chief objective, which is to prevent future financial crises, SMEs should derive greater benefits from them than larger businesses, even if there are any difficult side-effects.
Source from the SME Finance Monitor 2011 and 2012
The table suggested that bank loans are the most frequently used sources of finance (25% of the respondent sought out bank overdraft) [1] . Although the study did not show the influence of trade credit for finance purpose, the study did show that bank finance has been the most frequently used for working capital and source of cash flow by SME across business sectors. Amongst these SME that use this overdraft facility 28% said that they used an overdraft frequently, while at the other end of the scale, 44% rarely use it. However the data did not provide the certain percentage of respondents that specifically sought for trade credit compared to bank overdraft. But half of the SME do not rely on any of the external finance it is therefore assumed the half of SME respondents get their credit from the supplier or use retained earnings since the study did not show the percentage of SME that use supplier credit or retained earnings. This evidence is consistent with the results from the Federation of small businesses UK voice of small business survey February 2012, which showed that about 35% is used , 17% respondent used supplier credit compared to bank overdraft (35%) followed by own saving of business owners and retained earnings (FSB, 2012). It is assumed that small businesses compared to medium and large SME use personal funding and retained earnings in financing, (showing in figure 4.2) because it's less risky and the requirements to obtain bank finance is expensive. While other SMEs generally do not like to use bank finance because of the risk associated with it. If a business has a declining turnover, there do not need to source for raw materials or products because of their declining turnover.
Source of the FSB UK voice of small business survey February 2012
4.4 Credit terms
A credit term represents a set of economic decision around payment period, the method of payment and interest for late payment. When the delivery and payment do not occur at the same time, payment arrangement defines credit terms. The seller may require the payment before the delivery which is usually in cash, where the buyer bears all or most of the risk. However, when the seller allows the buyer to delay payment, the seller assumes the risk of collecting receivables on the due date. The existing literature has indicated two forms of credit terms, the simpler form is the net term (Howorth and Reber, 2003, Paul and Guermat, 2009, Wilson and Summers, 2002).
Wilson and Summers, (2002) define net term as a period for which full payment will be made. For instance the normal average trade credit term offered in the UK is 30 days, meaning that full payment is due in 30 days after the invoice. Typically the form of credit period is usually common among small firms, manufacturing and service sectors. On the other hand, the two-part term is the most complex form that has three elements, discount rate, discount period and due date. The supplier has specified the net terms but also species a shorter period which attracts a discount period. The discount rate is the percentage rate which is given on the net period, in which the buyer firm can pay a less amount on the invoice with a shorter period of time also known as the discount period. For instance a very common trade credit term is the 2/10 net 30 , meaning that a buyer can obtain 2% of the full payment if, the buyer can make payment within 10 working days, otherwise the payment will made in full in the 30 days (Wilson and Summers, 2002). These kinds of terms are usually found in the construction sector because of the structural complexity. The sector embodies very long lead times that predictably involve a sharing of project financing costs throughout the supply chain. The terms also exist in large and large to medium scale SME firms, while the manufacturing and wholesale are peculiar for granting discounts on the invoices.
The secondary data used in this study provide little evidence into the choice between the net term and two -terms, however the study will make reference to the empirical result of Wilson and Summers, (2002). The results of Wilson and Summers, (2002) did explain that the choice between choosing a two-term and net term is determined by the product innovation and market characteristics. The customer is likely to require a longer inspection period, if the quality of the product is difficult to determine. Ideally the seller would like the buyers to shorten the inspection period. The two part term may therefore be expected. According to the Wilson and Summer, (2002) there was a sector-specific aspect to this , for instance the large retailer sector are likely to exercise the two-part term where there is a high level of repeat purchase activity. On the other hand, small firms may as well offer a two-pert term to large customers as a sign of trust and reputation, but at a lower cost in cash flow terms. This is an important factor for smaller firms with more restricted access to institutional finance (Wilson and Summers, 2002).
Setting of credit terms allows suppliers to mitigate the risk to the forms of advancing credit and to maintain a reasonable degree of control over cash flow. Regardless of firm size, both customers and suppliers need to make appropriate arrangement for negotiating and then either paying or monitoring and chasing trade debts. The terms of payment on business to business sales can take many forms and a wide variety of possible payment terms can be offered. The failure of suppliers to sets terms frequently appeared to result in late payment issues. Customers may choose to negotiate terms, ensuring that they are favourable and indeed possible for them to meet. The customer takes advantage of their position to demand inequitable terms. Poor organisation among suppliers and customers such as, not issuing invoices promptly could be seized upon as evidence that a supplier would not chase for prompt payment (ACCA, 2012).
In a Pan-European level the European Payment Index survey 2012 shows that the average payment period for business to -business transaction is 25 days with an overdue period of 19 days. This figure is also similar to the UK voice of small business survey 2012 which shows that 69% of small business is between 28 to 30 days as their payment period.
The practice has shown that trade credit terms are heterogeneous not just between sectors but the supplier- customer relationship (ACCA, 2012). Recent researches have shown that the terms set tended to vary in response to individual circumstances. There is much scope for flexibility and treating customer differently depending on their importance, short term financial circumstances, and the opportunity for developing repeat business.
Case study analysis-
According to the ACCA, (2012) survey suggests that credit terms vary enormously according to the size of the firm and individual circumstance. Many of the firms in the survey sample appeared to have a considerable amount of vibration in the credit terms arising from their size, the structural attributed of the sector and nature of relationship with customers (ACCA, 2012). Their case studies highlighted some bases for which credit term sets vary;
Sector Analysis
The survey did show some evidence of the reasons for variation in credit terms types between the sample sizes. ACCA, (2012) reported that nearly one -third of their respondents belonged to the construction sector and they all cited 60 days as their normal credit term. This is because of the complex nature of their supply chain that result in issues often involving long time period depending on when their work was certified. Another similar sector is the engineering sector (large and small) which experience a long period of more than 90days for key customers. The credit terms in large service businesses vary between 10 and 120 days for large firms while smaller firms offer shorter credit terms between 7 and 30 days (ACCA, 2012. p26). In addition, the respondents were asked the standard term that used by SME and small business in the UK and a number of them did mention that the credit terms vary among the business sector. This study was similar to the FSB survey on the late payment 2011, suggested that small construction firms (67.3%) and manufacturing firms (76.7%) cited 30 days as their normal credit term while the small businesses in the Hotels, restaurants, bars and catering (65.6%) preferred their payment terms either before or on delivery of the goods and services (FBS, 2011).
Nature of relationship/power asymmetry
Wilson and Summers (2002) argued that firms vary the terms in anticipation of capturing new business, to attract specific customers and in order to achieve specific marketing aims. The previous chapter has explained the phenomenon behind the information asymmetry theory and relationship with trade credit. Suppliers get enough information about the customer credit worthiness through their trade relationship the bank (Lee and Stowe, 1993, Paul and Boden, 2011, Pike and Cheng, 2002). Paul & Boden, (2012) have indicated in their findings that many of the business supplier credit terms were determined by to the pattern of their customer profile.
…………….."One medium -sized company in the distribution sector set itself monthly sales targeted and adjusted credit terms to assist with meeting these objectives………………" (ACCA, 2012. p. 25)
This factor goes in line with Pike and Cheng (2002) price discrimination theory as well. Suppliers are flexible in their approach to credit terms, the size of the orders and customer demand. This is also peculiar in sectors that offer seasonal goods. In addition, the survey asserted that the present economic crisis has an impact on the credit term variation. Suppliers often demand for cash on delivery if the customer credit profile is acceptable.
A further indication in the ACCA, (2012) report, shows that credit that term variation creates room for the power asymmetry between the supplier and customer. This is very common between large business and small businesses. The large business uses their bargaining power to obtain more credit term or extend their payment period, making it difficult for the small firm to object to the changes. Largely because of the poor quality of credit function or policy that they were small business possesses (Wilson and Summers, 2002). On the other hand the small business may have no choice but to go along with the terms if the large business is the only customer of the small business, the profitability of the small business may depend on the number of purchases the large business makes. The source of the bargaining power may have to do with market structure but may reflect reputation financial strength and stability of the customer relative to the seller. Indeed this might be expected that supplier will vary terms of potential for relationship development, but one cannot stop to wonder if the supplier will be protected for the customer credit management failure in case liquidity problems,
4.5 Late payment Issues
Late payment can be defined as the payment made outside the agreed credit terms or payment that exceed the agreed payment time. Late payment of trade credit and its subject effects on cash flow are problematic for all business especially for small businesses. When processes such as being paid for the goods or services sold places strain on young business people for instance when it comes to paying staff or missing out on growth opportunities, it will lead to businesses closing. The late payment subject has been a long standing issue with which various authors have provided both quantitative and qualitative evidence of the consequences for small UK businesses. (Howorth & Reber, 2003; Chittenden & Bragg, 1997; ACCA, 2012; Pike & Cheng, 2002; Wilson & Summers, 2002)
The impact of slow or no payment can be devastating for small businesses, eroding the profitability of the sales and eliminate profit margins (ACCA, 2012). As indicated in the previous chapter, trade debtors are the riskiest asset that UK SME is likely to have on their balance sheet. This makes late payment prominent issues in the UK SME. Late payment also creates a negative cycle where late payment runs through supply chains or throughout suppliers should an invoice become overdue, action against kept of all actions and promise (Paul and Boden, 2011, ACCA, 2012, Pike and Cheng, 2002). This line of argument suggests that poor financial and credit management practice is actually at the late payment problem.
Graydon/Forum of private business analysis concluded that late payment of trade invoices is a serious problem over the last few years (FSB, 2012). The survey collects information on the payment culture and working capital management of SME employers. From the chart below, represents a graphical description of the serious impact of late payment by the small business respondents. All the respondents in the survey cited that late payment of trade invoice was a problem, with 23% saying it has become a serious problem; while 28% cited late payment as small problem. However the chart also reveals that late payment is slightly a problem for small business from a general perspective. In total 51% of respondents consider late payment a problem (combination of the 23% that cite late payment as a big problem and 28% that it as a small problem). This proportion is larger than those that 49 % of respondent that cited late payment as not a problem.
Source for Graydon/ Form of Private Business April 2012
The research also highlighted the domino effect of late payment through the supply chain, with 56% of respondents who did receive payment on time saying they were unable to pay their own suppliers on time as a result. Late payment has become less pressing as an issue, but for those it does affect there is a noticeable link to other issues such as lack of access to finance or the cost of finance. Late payment has become less pressing as an issue, but for those it does affect there is a noticeable link to other issues such as lack of access to finance or the cost of finance.
Late Payment- by Sector
Source data from the FSB Late Payment 2011
Respondents to the FSB late Payment 2011 indicated that late payment of trade invoices was more prevalent amongst private sector business to private business (76.8%) , followed by the local authorities (13.1%) (FBS, 2011).
The Graydon/ FPB (2012) survey reported a slightly larger portion of respondents were likely to see private manufacturing firms and construction firms as the most widespread late payer ( 87.1%) compared to the public sector where the businesses in the hotel restaurants, bars and catering see the local authorities as late payers (Graydon, 2012). It is agreed that the business in the hotel restaurants, bars and catering get paid immediate or pre-payment because of the nature of goods and service that is offered, payment beyond the stipulated payment time will considered late. There is the possibility that local authorities are likely to treat the hotel restaurants, bars and catering like any other business like in the construction sector, taking time to make payment.
A comparison with the research undertaken by Graydon/Forum of Private business 2012 also indicated that late payment is prevalent in private sector (81%) as compared to public sector (18.9%). They suggested that the structure of large private company contains some level of bureaucracy (long number of signatures that is needed); the payment times are structured that it may take a long time to approve payment.
The debt collection company, Intrum Justia undertook an annual survey of business across 28 European countries and compiled data on the average payment period (including overdue). In the 2012, survey the UK rank 16th out of 28 in terms of total payment period and 22 on payment losses. The survey indicates that the UK has improved the payment losses from 2009. The study shows the
Source data from the Intrum Justia European payment Index 2012 and 2009
From the table above it is suggested improvement in payment behaviour in peculiar countries like the Nordic countries, with UK ranks better than in 2009 while countries in southern regions of Europe with Greece take 85 days to be paid on average followed by Italy, which had a of 75 days and 70 days for Spain all recorded to have the worst payment times, as compared to the UK which has shown a drop in the their payment term from 30 days to 25 days (Justia, 2012). The feedbacks from the survey have a shown that the economic recession was a major factor in liquidity difficulties in debtor firms. Supplier firms shorten the credit period and payment times to avoid writing off potential bad debts. It is assumed those suppliers are taking a defensive stance against late payment through purgative methods like constant calling the customer and striker credit negotiations. This however is no totally a cause of the economic recession but a consequence of the type of relationship between the supplier and customer.
The table below compares the payment delay index between 2009 and 2011 across the European countries. The table shows that in 2009 and 2012 the delay in getting payment beyond the agreed term has stretched as a consequence of the global recession. The quantity of liquidity appears to be greater in Greece, having the highest payment delays among the countries show an increase in the days from 35 in the 2009 to (40) days in 2012 (Justia, 2012). While the UK shows a slight decrease from 20 days in 2009 to 17 days in 2012.this goes to show that the Greece liquidity problem is far from improvement and has been influenced by the consequences of the global recession. Bad write -off is likely you increase in these countries resulting in business failures.
Source data from the Intrum Justia European payment Index 2012 and 2009
Both results show that a vast majority of the business transaction across the Europe are undertaken on a trade credit basis and late payment is a serious problem from companies even after 4 years. However, the stated reasons for late payment are slightly significant differences according to the respondent. Arguable the late payment cannot be caused by the recession as there is the tendency of business to attribute the late payment to the cultural factor of these countries in their region. Paul and Boden, 2012 highlighted this reason mention that there is a clear difference in payment culture with the different regions of Europe; particularly the Southern counties have an anti-payment culture.
The respondents in the Intrum Justia survey have attributed reasons for late payment to liquidity difficulty of the debtors (Justia, 2012). Customer can make payment on the due date if it can sales of the goods received from the suppliers. This is based on the premise that the present economic downturn in 2012 will make access to finance more difficult for the customer.
A related line of argument suggests that poor financial and credit management practice is actually an act of the heart of the late payment problem. Market power or uncertain customer can delay payment to their supplier simply because the supplier is inefficient. Customers who can take advantage of their market position will demand inequitable terms of their supplier. Paul & Boden (2011) have postulated two situations in which late payment may arise. Firstly, when the terms of the trade credit agreement are breached and payment is delayed beyond the agreed date. The second aspect: when power asymmetries are such that the terms of the trade credit agreement unfairly disadvantages the suppliers. Large customers may have a power advantage over the supplier. In short, it may take a variety of forms and needs to be considered in the long run.
Reasons for Late Payment
Paul & Boden (2012) survey underlined that there is no formal reason why their customer pay late. But there were a variety of reasons which ranged from issues of structure, management and bargaining power, to geographical, cultural and sector-related issues. The probable cause of late payment is default in payment. But in reality the reason and situations will vary from firms to firms. To understand the various reasons for late payment, a comparison of ACCA, (2012) and Graydon/FPB survey 2012, will be analysed. The reason for this is not just have a detailed picture of the reason why late payment occurs in trade credit relations but to also supplier the reason with their empirical evidence.
Liquidity Of Debtors
Aside from the unpaid invoice by customer, many respondents in the ACCA, (2012) cited that late payment is cause insufficient funds in the accounts surprisingly the latest SME finance monitor survey reported that 63% said that they typically held less than £5,000 and this has changed little over time. Details of data are collected from the Q3 &Q4 of 2011. The data represented in 2012 contained information collected from the previous quarter of 2011. Consequently, the same data also show a slight increase in external finance over time, with 23% of the SME respondents citing that they use bank overdraft. Another reason that was cited in the Graydon survey was the lack of affordable bank finance. This is put as a major reason for late payment. The SME business barometer shows that 43% respondent finds it difficult to find bank loan.
Quality of product
Peter and Rajan, (1997) have demonstrated that trade credit is extended on the basis that the customer asses the quality of the product or services. This phenomenon lends much support for the product quality theory proposed by Smith (1987) that longer credit periods are extensive to permit product verification or which can cause late payment. According to the Graydon/Forum of Private Business 2012 survey, 61% of SME saw their reason for the quality of the work done by the supplier, while 38% of the respondents reported this as a minor issue
Other reasons that were common in both surveys were poor supplier invoicing and credit process. The Graydon/Forum of private business 2012 survey finding also shows that the poor organisation such as poor invoicing and credit process of which 13% of the reported this as an issue this is also closely allied to the concerns over the quality of the work done by supplier 21% reported this as an issue. One interviewee in the Paul and Boden (2012) survey mentions poor system for credit control and poor definition and articulation of trade credit terms as a frequent cause of late payment.
Power asymmetries were also mentioned as a cause for late payment. This is a very big issue for small supplier. However, the Graydon/Forum of private business found this as a minor issue, as 19% reported dispute over timeliness or quality of goods. This phenomenon is demonstrated in Paul and Boden, (2012) survey. They argued that large customer did indeed use their position of power in trade relationship. To quote their statement in their surveys
"One interviewee described a major retail as just a pain they will eventually pay and eventually find various reasons to take deductions for reasons such as promotion, quality and quantity breakage"(ACCA, 2012. p. 35)
Similarities between the reasons for late payment
Reasons for Late Payment
Paul and Boden 2012: Getting Paid, Lessons for form SMEs
Graydon /Forum of Private Businesses : Research on Payment Culture 2012
Cash Flow Problem
The firms said that they do not pay because they have not paid themselves. The problems are acute in Construction companies with long supply chain involving many subcontractors
73% of their respondents indicated that the late payment was caused by delays in payment from tier customer.
Disorganisation among Supplier and customer
They noted that signal of organisation such as not issues invoices prompt, could be seized upon
13% respondents reported this as a major issue
Quality of Product
Their survey shows that incorrect billing of quality and quantity, delivery price was the major issues. "One interviewee described a major retail as just a pain they will eventually pay and eventually find various reasons to take deductions for reasons such as promotion, quality and quantity breakage"
61% of SME saw the reason of the dispute over the timeless / quality of work done by the supplier.
Methods of mitigating late payment
According ACCA, (2012) late payment is a two way thing, meaning that both the supplier and buyers are on the flats when it comes to payment defaults. The big difference in effective method of mitigating late payment Is the actual impact of late payment on the business (ACCA, 2012). Those who felt that the late payment was most problematic for the business were more likely to have used a variety of methods.
Late payment can be mitigating when both supplier and customer have clear policies, engage with credit terms and are effectively organised. The Graydon/FPB survey 2012 provided the effectiveness of methods which the respondent has indicated as;
Effectiveness of Usage of Methods of Mitigating late payment
Source data from Graydon /Forum for Private Businesses Survey 2012
The table above shows that almost all businesses who felt that the late payment was most problematic submitted invoices promptly (99%) were the most likely to find this to be effective. They also use a variety of methods to get prompt payment like regularly calling the customer before (73%) and after (92%) the submitting the invoice (Graydon, 2012). It is assumed that this method is an effective way for small suppliers that find it difficult in collecting payment from large customers.
Those who saw late payment as a minor issue were marginally more likely to refuse to complete the work or stop future delivery (85%). The particular kind of businesses that use this method are the services business, where services are needed on a continuous basis (Graydon, 2012) . A good example will be businesses in the IT services and businesses and food and beverages sector. On the other hand this method in other industries may cause the business to lose a major customer to another competitor in the future. In contrast, invoice discounting, and debt collection were the least effective method, largely because then they are expensive to obtain.
4.4 Trade Credit insurance
Credit insurance is a financial tool used to manage risk of cash flow from trade debts, for all firms extending credit to customers involves a certain amount of risk (Jones, 2010). In any trading climate, protecting your business from the danger of bad debt on business sales could make the difference to your business survival. Sales are hard to come by even in the best of times and the effect of bad debt on profitability can be disastrous. The sales of goods and services are exposed to a significant number of credit and political risks, many of which are not within the control of the supplier. The highest of these risks and one that can have a catastrophic impact on the viability of a supplier, is the failure of a buyer to pay for the goods or services purchased. Political risk involves the non-payment under an export contract or project due to the actions or inactions of a buyer's government. These risks may include currency inconvertibility; transfer of payment; war and civil disturbance; confiscation, expropriation and nationalization, etc. (Jones, 2010). Pike and Cheng, (2002) comparative study, indicated that credit insurance has a higher rate of achieving payment targets (38%) compared to the US and Australian firms than invoice discounting and direct debit (Pike and Cheng, 2002).For large UK-based companies, doing business globally and seeing the world as an increasingly attractive marketplace, credit insurance is essential as it allows companies that export to protect themselves against any transaction cost incurred from delivery goods to a buyer in another country which may delay payment. The commercial risks may include the insolvency of the buyer and extended late payment, which is the failure to pay within a set number of days of the due date (normally 60-180 days) and is known as protracted default.
Credit insurance minimise the risk of cash flow problems and insolvency of the supplier business by protecting the supplier's against the possible default in payment and insolvency of the customer. Being credit insured can have an advantage with banks, and suppliers as their cash flow tend to be protected. Furthermore, supplier influence their customer to settle their invoice sooner by letting them know of the credit insurance before goods are received.
A recent study by the Credit Management Research Centre (CMRC) at the University of Leeds for credit insurance company Euler Hermes, found that the credit insurance policy can foster better relationship with supplier. 90% of credit insured companies stated that supplier is willing to offer trade credit compared to 73% of the non-insured companies. Credit insured companies experience more stable relationship supplier because they are protected against payment delays and protracted default that may lead to bad debts (CMRC, 2006). The survey also revealed that those companies with credit insurance were more likely to indicate that they received preferential credit terms from their own suppliers thus improving the overall cash and working capital cycle. Credit insured firms are more likely to gain the confidence of the supply chain because their own cash-in position is more certain and therefore they are less likely to pay suppliers late.
Source data from the (CRMC, 2006)
Emphasis on impact of credit insurance may attract new customers in all markets and particularly SME. Particularly when such SME businesses find it difficult to pay their own debts, purchases essential materials and even pay wages. Given that SMEs are the predominant form of business across Europe and the globe then the potential market for credit insurance and credit management services is huge as are the potential benefits to the SME sector (Wilson, 2008). Small businesses are recognising how much credit insurance can offer invaluable protection. Conversely, the CMRC 2008 study of SME businesses suggests that SME have less than 3% penetration of credit insurance in the UK compared to around 30% in the largest companies. The main reasons cited were that credit insurance was perceived to be too expensive (68% of firms). However, those SMEs that were devoting more time to credit management (credit insurance) had: a greater proportion of their accounts paid on time, lower levels of bad debts, lower average debtor days (controlling for credit periods), and perceived less of a late payment problem (Wilson, 2008). Credit insurance can be made more attractive to the SME market through increased automation to both reducing the cost base of the service and reduce the administration by developing better software interfaces with the client and simplifying the reporting/claims process.
