Importance of Trade Credit Management

An Insight into Strategic Trade Credit Management in UK Companies: a Taste of What’s to Come

By Dr. Salima Y. Paul[1]

“Credit has the power to drive your business beyond your ambition. Effectively harness this power and it will prove the foundation of your business success. Let this power out of control and it could destroy all your efforts to build a flourishing enterprise.”[2]

This is an introduction to the series of articles I shall be submitting to this journal for publication over the coming months. I wanted so much to show my appreciation by sharing my findings with all of you out there who very kindly filled in the lengthy questionnaire, those who agreed to be interviewed either by phone or face-to-face and those who simply volunteered to answer queries from time to time to clarify puzzling findings and who assisted whenever needed (Special thanks to my ex-students who now work in credit management). Without the help of those of you who, like me, are very passionate about credit management, my research would not have been possible. I would like to acknowledge the expertise of Professor Wilson and his invaluable contribution to the successful completion of this work[3].

I shall be reporting my results regarding many areas of credit management and the role it plays as a core function within an organisation. My findings are based on responses from 355 companies to a very extensive postal questionnaire which gathered data on a number of areas related to trade credit management and business performance. Some 900 items were collected within ten blocks of questions[4]. When matched with the financial information obtained from Creditscorer Limited, the survey provided very rich data. As the questionnaire was sent under the aegis of the Credit Management Research Centre[5], a body known to many credit managers/controllers, this increased the response rate. Moreover, for the areas studied, it was considered inappropriate to restrict ourselves to the questionnaire alone so interviews were conducted to help build more comprehensive data. Informal face-to-face discussions with groups of credit managers/controllers that we met at ICM seminars were very useful and the source of ongoing contact with the interviewees. Subsequently, these mangers/controllers were asked if they would be interested in participating in further research with the aim of expanding on issues that had not been fully picked up by the informal meetings. Most of them volunteered to be interviewed over the telephone and those for whom this was not convenient provided names of the persons responsible for credit management within their firms. Therefore, from the many interviews conducted, we were able to generate ideas which related to areas interacting with credit managers’ perceptions and beliefs and which looked at the reality individuals create by their practices. Moreover, as the sample frame was selected from a broad range of sizes, sectors and locations, the selection process employed in the study allowed every UK based company the possibility of being selected (the tables below show the population of percentage firms, in our sample, by industry sector and by size).

Predominantly, credit management is regarded as a passive consequence of sales and therefore the credit manager (often seen as a debt collector) fulfils a somewhat prosaic functional requirement which embodies an emphasis on the “back-end” activities. Results from our survey show that on average more than half of trade credit management’s effort is devoted to chasing and resolving unpaid/disputed invoices[6]. Consequently, this approach fails to recognise the potential importance of sedimenting sound trade credit management policies and practices through all commercial operations, and ignores the effect trade credit management can have on the company's overall performance.

The recessions of the 1980s and early 1990s forced a corporate re-evaluation of the importance of trade credit control. Those firms that did not survive were not necessarily unprofitable or/and inefficient but were ruined by illiquidity which in many instances was related to late payment and bad debt write off. Credit managers, especially in small companies, started to understand not only the importance of cash-flow budgeting but also the contribution that credit management could make to their cash conversion cycle[7]. If used effectively and proactively, trade credit management can reduce this cycle and “hold the key that can unlock precious cash resources”[8] tied up in trade debtors. Moreover, granting credit allows better cash-flow management as, with credit sales, timing is more predictable and therefore the costs associated with liquidity problems are reduced. Even those firms that tend to be more liquid would be able to reduce the opportunity cost of cash held for precautionary motives. Furthermore, trade credit extension may have the power to reduce many other operating costs[9] associated with cash dealings.

However, there is much more to trade credit than just a cash control tool. It can play a significant role in strategic decision making and may have an impact on a company’s overall efficiency, profitability and long-term survival. Trade credit is gradually becoming an important element in firms' strategic decisions and a potential source of competitive advantage (Wells 2004) that can be achieved through the use of sound credit management of policies and practices. By linking credit objectives to their overall long-term goals, companies can acquire valuable information on customers, and on marketing and pricing decisions, invest in long-term customer relationships, enhance their reputation, and create cost and operational efficiencies. Moreover, trade credit can play a major role in attracting new customers, in building supplier-customer relationships, and in signalling financial health and confidence in product quality (Peel et al, 2000). However, trade credit can only be a powerful strategic weapon if it is used proactively and its process is managed properly. Well thought out policies, clearly stated and adhered to, provide the best protection against loss of profit through the cost of granting credit and bad debt write off; checking creditworthiness, for instance, and agreeing payment terms and conditions could save firms from financial difficulties.

Although some companies have started to recognise the importance of credit management and the contribution it makes to their financial health, we wanted to raise its profile even more by showing how vital credit management is to all firms who sell on credit and our findings show that there are many out there: 86.4% of our respondents sell between 80% and 100% of their goods and services on credit (a third grant credit on every business transaction).

There is widespread recognition that credit managers control one of the biggest and most important assets companies are likely to have[10]. Surveys[11] conducted in the UK show that, on average, more than 80% of firms make the bulk of their sales on credit. Consequently the trade debtors figure in firms' balance sheets is estimated to be on average 37% of the total assets in 2003/04[12], as against 35% in 2000 (Summers and Wilson) and only 21% in 1990 (Pike and Cheng, 1996). Moreover, Wells (2004) finds that businesses have an average of 28% of their assets in outstanding trade debtor balances. He cites the example of British Petroleum which has some US$26 billion locked up in its trade debtors. This suggests that firms may have to comply with industry norms with regard to extending trade credit if they are to achieve necessary levels of sales and to stay competitive. For some companies, especially SMEs, growth and survival depend on whether they are able to get credit to finance their activities and in turn to grant competitive trade credit terms to attract customers with the aim of building long-term relationships. However, it is claimed by many that trade credit is the most important but riskiest asset a company is likely to have. This is shown by the size of trade debtors to firms' total assets ratio and the magnitude of the late payment and default risks.

Companies must have clear policies and effective systems to manage the levels of credit granted to their customers with the main aim being the prevention of delayed payment, which has become a major factor behind the business failure rate, especially for smaller firms. It is often claimed that too many companies still fail due to poor credit management[13]. The late payment problem has attracted more attention than any other issue regarding credit control. Singleton and Wilson (1998) analysed a sample of small firms and found that those companies that managed their credit efficiently were less at risk of failure than those whose credit management procedures were ad hoc. Our results show that firms that suffered most from late payment were those with poor credit management practices. It is often argued that profitable businesses can fail through lack of cash-flow caused by being paid late[14] especially those whose main priority is to preserve a customer relationship rather than timely cash collection (Summers and Wilson, 1998). Evidence suggested that payment periods continued to lengthen: over half of the UK’s small and medium enterprises claimed that payment time worsened despite improved economic performance and only 12% of SMEs received payment within 30 days[15]. Our survey showed that 89.4% of firms have often, or at least quite often, been paid late and over 20% receive their payment after 30 to 59 days and nearly 10% are paid at least 60 days later. Consequently, many firms have been driven to an early grave by the problem of late payment or default which can be reduced by improving the credit management function[16]. If trade credit management is given the importance and status it deserves, it may contribute to the global economy.

As an example, we examined the level of investment that companies have made in stock management control systems and trade debtors management. This process was conducted by comparing both stock and trade debtors to total assets and current assets[17]. An interesting picture emerged: trade debtors to total assets went from an average of 19% in 1977 to over 30% in 2004; while stock to total assets which averaged over 35% in 1997 reduced to just under 10% in 2004. The same picture emerges when comparing trade debtors to current assets and stock to current assets. Stock to current assets which started as the highest, averaging 60% in 1977 was down to just under 19% in 2004; whereas the average trade debtors to current assets which was 35% in 1977, peaked at 55% 1995 and was at just over 48% in 2004. This shows on the one hand the relatively high level of investment that companies have been making in stock management control systems to free up funds tied up in stock as against the negligence of trade debtors management on the other.

Comparison of Investment in stock management

and trade credit management

Despite its apparent importance, trade credit has been a much-neglected area. The evidence of this has been observed by many over recent decades through the lack of attention given to the subject theoretically and empirically. It is evident from this research that the credit management function and the place, role and organisational position of credit managers may be re-evaluated in the light of the importance of trade credit and its impact on the company’s cash-flow, its balance sheet, its performance and, in the case of small and medium businesses, even its survival. Effective credit management can influence corporations’ strategic decisions generally and marketing and sales policies specifically, by being proactive in the “front-end” activities and by pursuing predetermined credit policies. However, there is a dearth of information about how credit policies are actually formulated and applied and the reasons that drive companies to choose different policies and practices.

So this series aims initially to shed light on policies and practices in UK companies and then to examine different ways firms can use trade credit management proactively as a competitive weapon that can play a significant role in strategic decision making and have an impact on overall efficiency, liquidity, profitability and long-term survival. Therefore it will explore the importance of trade credit management and the factors that influence the offer and usage of trade credit seen from the point of view of an individual company/business. It also considers how this research can inform credit managers/controllers of the way in which trade credit can be used strategically to create competitive advantage and enhance corporate performance.

[1] As a senior lecturer in Accounting and Finance (University of the West of England), I almost stumbled across trade credit management; I will tell you all about it one day when I finish writing my article about my academic life “outside” credit.

[2] Wells, R. (2004). Full references on this and subsequent articles can be obtained from the authors (especially for whose who are studying for a credit management qualification). I am contactable via ICM.