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Why Businesses Give Credit

What is trade credit and why do companies extend it to customers?

Trade credit is an arrangement where a customer can purchase goods or services from a business on account, paying later to settle the account at an agreed time. There are many different arrangements that businesses offer customers.

Supply chain financing (inter-firm financing) is an important source of funds for businesses. For example, Tesco plc had 4.9bn of trade payables on the balance sheet in its 2017 accounts, as compared with a figure of 2.6bn for bank loans and borrowings.

Steve Jobs and Steve Wozniak famously used trade credit to get their new business, Apple, up and running. They secured an order for 50 Apple I computers from Paul Terrell at The Byte Shop, who was willing to pay Cash on Delivery (COD). Jobs then contacted his component supplier Cramer Electronics and negotiated credit terms of 30 days net to purchase the parts to build 100 computers. After working day and night to assemble and test, the 50 computers were delivered and enough money to pay Cramer Electronics was collected. The future multi-billion dollar business had got up and running, with stock for a second order and a small profit left over without having to give away a single share to external investors.

These examples show how useful trade credit can be to the customer, but why with all of the risks of late payment, non-payment and default that come with it, would a supplier offer interest free finance to a customer?

You could argue that offering credit reduces the administration burden and increases efficiency for both parties. When a customer is placing multiple orders each month, week or possibly each day it becomes burdensome for both parties to require payment before sending the goods. Instead, all purchases in a period, are added up and a single payment is collected later. However, it doesn't follow that the customer has to be given credit. A customer could make payments on account - pre-paying for the goods they expect to order in the coming month and settling up any differences at the end of the month. Nor does this explain the prevalence of credit terms beyond end of month (EOM), such as 60 days and longer.

Indeed, with digital banking making transaction costs lower and reducing the time for payments to clear, it is possible to imagine that modern business could manage multiple payments each month with little additional overhead.

The simple reason is that companies extend trade credit to their customers because competitive pressures force them to do so. This is backed up by the finding that firms that face stronger competition in the product market are also more likely to extend trade credit and have a larger share of goods sold on credit.

Where the price and quality of the product from two potential suppliers is similar, the generosity of credit terms on offer could be the difference that clinches you the deal. For some, credit-constrained customers - the credit terms on offer may become more important that quality or price. Businesses that offer credit to their customers have a competitive advantage.

The good news is that with diligent credit control practices in place such as checking the credit worthiness of customers, getting your invoices right, issuing statements and contacting customers to confirm payments the risks can be reduced while taking the competitive advantages of offering credit to your customers.

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