Think at London Business School: fresh ideas and opinions from LBS faculty and other experts direct to your inbox
Delayed payments seem to be crippling small businesses in the UK. Government figures show that 47% of the country’s 5.5 million small-and-medium-sized enterprises (SMEs) are paid late, with customers owing them £26.3 billion (at the end of December 2016).
The threat of closure for small firms with cashflow problems has forced the government to take action. Since April 2017, UK-registered firms have had to provide supplier payment data – how and when they pay their suppliers – every six months as regulators look to make life easier for SMEs. Authorities hope that fines and the risk of reputational damage will prevent big companies from paying late.
Will the regulation work? Time will tell. In any case, the need for such regulation reflects policymakers’ concern about trade credit (a buy-now-and pay-later agreement between supplier and customer). Buyers that are given 30, 60 or 90 days to pay their bill often go beyond due dates. And they may find other ways to circumvent the new regulation, such as forcing suppliers to accept longer payment terms.
Nevertheless, I believe British businesses would grind to a halt without trade credit. Research in this area – carried out by my co-authors and I (see footnote) – shows why companies either demand or offer it. Most businesses use trade credit, despite its inefficiencies. Without it, most companies would struggle to operate.
Companies use trade credit for various reasons. For instance, delayed payment allows buyers to hold sellers liable for low-quality products or services. In addition, our research shows that trade credit helps companies mitigate the risk of buying products that may not sell. When ordering sweaters from its supplier, the retailer doesn’t know how many customers will snap them up. The retailer carries all the inventory risk, so it would order less from the manufacturer. That in turn hurts the supplier, the buyer and the consumer because there may not be enough jumpers to meet demand, leading to fewer sales and less revenue.
In this case, trade credit serves as an implicit risk-sharing mechanism. A buyer that piles up inventory and sells few jumpers may delay its payment to the supplier and say, ‘I haven’t hit my sales target so I won’t pay you on time. Let’s wait until next month to see if I sell more’. While seemingly undesirable for suppliers, risk-sharing incentivises the buyer to stock more jumpers. That then boosts the supplier’s sales. This type of arrangement increases the size of the pie for everyone in the supply chain, because the buyer has the confidence to invest more in inventory and that generates more money for all businesses involved.
The risk-sharing role of trade credit goes beyond demand and inventory risk. Our research shows that companies in a supply chain can use trade credit agreements to pool their cash reserves for unforeseen setbacks that may prove costly. For example, a manufacturing company might have to spend big on new equipment if a critical piece of machinery breaks down.
It would be extremely costly for companies with no credit facility to approach their bank every time something goes wrong. As such, businesses may hoard cash to protect themselves from an emergency. Under a trade credit agreement, organisations in the supply chain are effectively pooling cash reserves in one account and can use the money whenever it’s needed. Such pooling clearly improves the utilisation of cash.
In addition to better orchestrating the buyer-supplier relationship, our research also shows that trade credit may allow competing firms to better co-ordinate. When asking managers why their firms offer trade credit to customers, the most common answer is to match what their competitors do – even though it may further burden their already strained finances. But our research shows that this additional burden could actually help the seller.
The mechanism behind it is related to the classic Bertrand competition model, where companies grab a larger market share by selling goods for slightly less than their competitors, leading to extremely low margins. But the situation changes when they offer trade credit. The seller’s cash is tied up due to its repayment agreement with the buyer. The upshot is that suppliers offering trade credit are less likely to engage in a price war, resulting in a healthier margin for their industry.
While I advocate trade credit agreements, there are drawbacks. Suppliers can offer incentives such as an early payment discount, but that doesn’t mean big companies will pay within the agreed period. I hope big businesses will be spurred on by the UK government’s supplier payment disclosure regulation to adopt a more co-operative approach. However, regulation is rarely, if ever, a panacea and it must mostly always be complemented by various market-based approaches. In the context of trade credit, supply chain finance, which involves lending based on sound business transactions and supply chain relationships, may help mitigate some of the drawbacks while keeping the benefits.
The basic idea of supply chain finance is simple: when making lending decisions, the lender should look beyond the four walls of the borrower and examine the whole supply chain.
In one type of supply chain financing programme, known as reverse factoring or invoice discounting, smaller businesses can receive cash or a loan at a discount based on invoices submitted to their clients. The idea is that a supplier secures an attractive rate of interest based on its transaction with a big company such as Tesco, for example. The bank knows that the money owed to the supplier will get paid as it’s coming from a major organisation, whose default risk is low.
It’s a sound idea in principle. But in practice, lending based on invoices without knowledge of the specific transaction can be risky. For example, the lender may not know what state the goods are in or if there’s a valid reason for delaying payment. Other supply chain financing programmes such as purchase order financing require in-depth knowledge of supply chain transactions such as the supplier’s performance risk (whether a supplier can deliver its orders successfully).
To make supply chain finance work, companies need to collaborate with various players such as banks (or specialised supply chain lenders), buyers, supply chain intermediaries and service providers, and credit insurers. Hopefully, advanced IT will streamline the process and make the information flow smoother.
Traditional financial institutions may need to move fast to avoid being left behind. In fact, technology giants such as Amazon and Alibaba utilise their industry expertise and information when lending to businesses that use their services. Ride-sharing company Uber launched an auto financing scheme in 2015, where drivers received loans from the company to pay for newer cars. But the programme has incurred substantial losses, owing to the company significantly underestimating the adverse operational impact of the financial burden on its driver.
Supply chain finance isn’t simple, but we believe the future is bright. This field will directly benefit from the rapid rise of analytics and fintech. Data analytics and artificial intelligence allow financiers to incorporate more features based on supply chain transactions in risk management models. Meanwhile, blockchain and smart contracts can enhance information transparency and security for complex transactions.
Going back to regulation, one possible reason that banks are reluctant to lend is because of mounting red tape. The capital requirements placed on banks limits their ability to lend, especially to small businesses. But the government can help by taking a more supply chain-based approach when regulating small businesses lending.
Finally, beyond businesses, the new regulation also imposes performance targets for government agencies as payers. This should be welcomed. Traditionally, government agencies have been among the worst culprits for payment delays. Furthermore, many services for getting businesses paid quicker, such as credit insurance and factoring, often exclude government-related transactions. Therefore, regulation may be the best solution to tackle this problem.
Yang, S.A, and Birge, J.R. (2017). Trade credit, risk sharing, and inventory financing portfolios, Management Science, http://pubsonline.informs.org/doi/pdf/10.1287/mnsc.2017.2799
Peura, H., Yang, S.A., and Lai, G. (2017). Trade credit in competition: A horizontal benefit, Manufacturing & Service Operations Management, 19(2), 263-289
Tang, C.S., Yang, S.A., and Wu, J. (2017) Sourcing from suppliers with financial constraints and performance risk, Manufacturing & Service Operations Management, forthcoming.
Yang, S.A., Bakshi, N., and Chen, C.J. (2017) Cancelability in trade credit insurance, working paper, http://dx.doi.org/10.2139/ssrn.2735907
Hu, M., Qian, Q., and Yang, S.A. (2017) Financial pooling in a supply chain, working paper.
You must be a registered user to add a comment here. If you’ve already registered, please log in. If you haven’t registered yet, please register and log in.Login/Create a Profile