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Trade Credit where it’s due?

Gareth Rumsey

We all know the value of trade credit. By lubricating the wheels of business, trade credit gives companies flexibility and a means of managing their cashflow. It enables businesses to be paid, and in turn pay their own customers. It’s like a whole series of short term loans that keep businesses afloat.

The problem is the £4.7 billion drop in trade credit seen since 2009. This reduction has hit the whole economy, further restricting growth.

So why did trade credit reduce so much? While we saw a wholesale reduction in trade credit, there are interesting aspects. Clearly, many businesses ran scared – some due to the shrinking economy, others because of the credit crunch hype. Instead of planning for growth, they played safe and hoarded their cash. Others responded to businesses not paying them by cutting off their credit terms. Many businesses failed, particularly those who were using credit to prop up their business. We also saw that while credit was often being extended to larger business, this was not so for smaller businesses, who were viewed as riskier prospects.

The alternatives to trade credit have proved equally unbalanced. As interest rates went down, so we saw an increase in directors loans into their business. While this is fine, it’s not really what you want to happen. What about the businesses whose owners don’t have private funds to support them? Banks could lend more, but because regulators and the public alike don’t like the thought of banks taking so much risk they end up having to be bailed out by the taxpayer again, banks are becoming very risk averse, and reluctant to lend to businesses which may not actually be risky. Other forms of lending – such as The Funding Circle – may be  growing at an enormous rate, but starting from a standing position means they will need years before they can make a difference on a national scale.

For the good of the entire business community, not to mention the general economy, trade credit needs to be extended to more businesses.

So as well as doing the right thing for the economy, what are the benefits to you, as a business, of extending trade credit? Quite simply, it can also help win new business, being an effective lever when talking to a potential customer. When price and product are fixed, offering extended credit terms is a powerful negotiating tool. Beyond the tangible benefits of winning more customers and securing more business, appearing flexible and an easy company to do business with is also important.

The key is to do it prudently. So what can commercial credit managers do to ensure they’re right in extending trade credit?

Commercial credit reports are vital when taking on new business with credit terms. A credit score, combined with details on  business size, assets and liabilities, will help you define your credit limits and terms. A strong credit score and rating will help you gauge whether or not a customer is a risky prospect.

This is especially relevant at a time when the economy is emerging from recession and starting to grow again. It is likely that during this period we will see an increase in business insolvencies, not indicating a descent back into recession, but because some businesses overstretch themselves in their efforts to grow with the recovery. What would benefit such a business, and help it avoid going insolvent, is understanding suppliers who are willing to extend trade credit to ensure it doesn’t have to pay for all of the stock immediately.

Of course, things change over time. A business that is creditworthy today may not be tomorrow. So you might also think about monitoring changes in risk by daily, weekly, monthly alerts. Alerts for events such as a drop in creditworthiness, a director leaving, or the businesses becoming imminently at risk will reveal changes that materially impact on you.

A suite such as Business IQ includes credit reports for manual decision-making and an automated decisioning engine allowing you to set referral thresholds. A portfolio management tool enables you track risk within your entire customer portfolio according to your own parameters.

At a time the economy is slowly returning to growth, taking steps to extend credit to creditworthy businesses is not only good for the economy at large, it can also help your business grow and thrive when others may continue to struggle.

The financial news is plagued by stories of zombie takeover. According to some reports, the progress in the economy has been slowed by a large number of so called ‘zombie businesses’ that are only just staying afloat. Companies with few prospects for profit or investment, that are simply financing the repayments of heavy debt, are according to commentators in some circles, prohibiting the growth of healthy businesses and having a negative impact on the UK economy. Some commentators are claiming that there are more than 160,000 zombie companies operating across the UK alone.

As the expectation of an increase in business insolvencies grew, but insolvency figures continued to fall, zombies businesses were being put forward as a potential theory as many waited for an avalanche of ‘inevitable’ bankruptcies. And they are still waiting, as the insolvency rate remains stable and is hitting some of the lowest rates seen in the last five years. This begs the question – are these companies really too highly leveraged and too unprofitable to ever become successful again? Or do they just need time, understanding and a recovering economy to recuperate?

Moreover, where do messages like this leave other businesses that are looking to continue trading with a possible zombie? Their decision to trade becomes even more difficult, as they’re left wondering whether they’re doling out goods and services to companies who may never pay them, so putting themselves at financial risk; or whether they should play safe and risk losing the custom to someone else.

Making a realistic determination of a company’s situation is vital, to make sure that businesses are extending credit on suitable terms – and this is likely to be different for each business. It’s important that they’re not deterred from offering any trade credit at all. Access to trade credit is vital in helping many companies manage cash-flow, thereby allowing them to continue trading and ensuring the long term health of the economy. Most temporarily stretched companies can recover, if they’re given the right opportunity to do so.

Of course, business should always exercise caution, as feeding into terminally distressed companies won’t benefit them, their struggling customers or the economy. The lesson is not one of extreme and unwarranted restraint, but one that advocates adequate risk analysis. By assessing your potential and existing customers properly, you can make informed judgements about their underlying strength. Credit scoring systems for businesses can be used to predict the continuing stability of clients; giving an indication of their health over the next twelve months. Similarly, Payment Performance Data informs of a company’s recent payment history, which can give a clear indication of their repayment capabilities. If businesses are privy to accurate information about a customer’s payment habits, they are more prepared for subsequent conversations on why payments are being made late and what they can do about it. The possibility of extending payment terms may be an option. For ongoing monitoring and to determine if companies could be in imminent trouble, a Distress Warning Score alerts of new dangers in the credit score flagged by missed payments.

Businesses can also use their own customer data to assess the financial health of their existing clients and suppliers, which they may depend on for continuity – payment records reveal whether a company may be experiencing problems and if this is indicated it can be addressed accordingly and dealt with through positive dialogue. It’s also highly recommended for businesses to request at least three references prior to trading with another company, as this also gives a good idea of their reliability before credit is extended. In short, there are enough precautionary measures out there to protect businesses and help them make decisions that don’t, in the long run, increase their own bad debt experience and add to the economy’s problems. 

It’s true to say there are many companies experiencing problems with cash flow, and if a business finds that’s the case with one of their customers, then this must be handled delicately; as a business will either need to recoup their money before their customer goes insolvent, or maintain the integrity of the relationship for future trading once things have picked up.

There’s a significant difference between a zombie company, dead in the water with terminal debt; and one that simply needs a hand to become profitable again. Allowing 160,000 ‘perceived zombies’ to perish; could be doing more of an injustice to the economy than if they make some rational decisions about which ones are worth financing and selling to. We can’t expect a turnaround in their fortunes overnight, but if the world believes the zombie phenomenon, then the current financial challenges could last longer than they really need to.

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