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Managing Trade Credit to Sustain Competitive Advantage. “Any firm committing around one fifth of its assets to accounts receivable needs to give serious attention to why it is doing so and whether it is adding value to the business.” (R Pike, N Cheng and L Chadwick)

“Credit is seen as part of a total package, so as to enhance our position in winning business.  It is …. a competitive weapon.”

“We consistently look for new innovation to improve our credit performance”

“We should ask ourselves the following questions:

1)  Why do firms offer trade credit?

2)  How can trade credit policies be developed to create a competitive advantage?

A clear understanding of the rationale for granting credit to customers, as evidenced by a coherent and carefully devised credit policy, is an important strategic consideration.  Any firm committing around one fifth of its assets to accounts receivable needs to give serious attention to why it is doing so and whether it is adding value to the business.


THE ECONOMICS OF TRADE CREDIT

Trade credit is credit extended to a customer by a supplier of goods or services, thereby allowing delayed payment in accordance with the terms specified.

Poor trade credit management not only affects the firm; at an aggregate level it affects the (national) economy in terms of its international competitiveness. 

Demand for trade credit tends to increase with an interest rate rise, as firms look for a cheaper alternative source of working capital finance.

Trade debtors represent a significant proportion of the capital employed in most companies.

Large firms should be aware of the importance of trade credit management as a management function, in particular, its impact on improving competitiveness, profitability and cash flow.

 

TRADE CREDIT MOTIVES

1.  TO AID MARKETING AND PRICING DECISIONS

Trade Credit should be regarded as a promotional tool, not purely a financial tool.  Trade credit provision is an important supplier selection criterion, especially when suppliers offer an identical mix of variables such as price, quality and delivery.  Customers will purchase more from suppliers if more generous credit terms are offered.  Flexible payment terms can also be arranged to support customer needs.  The use of price discrimination (a selectively relaxed collection process) and/or inclusion of prompt payment discounts within the firm’s pricing policy could be valuable tools.

2.  TO MAKE WEALTH-CREATING INVESTMENTS IN ACCOUNTS RECEIVABLE

Accounts receivable should be regarded as an investment rather than the passive consequence of sales.  Financial theory argues that firms should invest in trade credit if the net present value of the revenue receivable ‘with credit being offered’ is greater than the net present value arising ‘without credit’.

The trade credit decision can also be viewed from a longer-term perspective, looking beyond the accounts receivable figure on the balance sheet.  Offering trade credit on “open account” provides a signal to the buyer that the seller is seeking to enter into a continuing relationship with the buyer.  It is common practice within many firms to demand cash with order, or on delivery, and to subsequently go through credit screening procedures prior to granting credit.  A powerful signal is therefore given to the customer through the granting of credit - namely that the supplier seeks a mutually beneficial long-term trading relationship.

3.  TO EXPLOIT FINANCING OPPORTUNITIES

For most customers the high transaction costs involved in raising money, from a bank for example, make trade credit a preferable financing arrangement - even more so where the supplier has access to financial markets at rates that are not available to its customers.

4.  TO ACQUIRE/OFFER VALUABLE INFORMATION

Offering credit to customers generates valuable information for firms. Offering two-part payment terms, involving prompt payment incentives, can be used as a screening device to identify the default risk of prospective buyers.  Those refusing to take generous discounts are likely to be experiencing cash-flow problems and will therefore require close monitoring.

Providing trade credit presents an opportunity to enhance corporate image, build goodwill and promote customer loyalty. Trade credit can also be interpreted as an implicit warranty, guaranteeing product quality.

5.  TO CREATE COST AND OPERATING EFFICIENCIES

The separation of the exchange of goods from the exchange of money by the seller offering a period of credit, creates a number of operating efficiencies and cost improvements.  Payment on delivery is an inefficient practice in both supply chain management and reducing payment transaction costs.
For example:

Multiple invoicing versus once per month invoicing.

Storage costs ‘transferred’ to the buyer, if the buyer’s storage costs are lower. Consider the case of fertiliser, which is a seasonal product, the supplier can offer credit and/or a discount if buyer takes on the storage commitment.

A survey of UK companies revealed the following as being the most common trade credit motives :

To win new customers.

To gain large orders from existing customers.

As a final “clincher” for a sale and/or when customers insist.

To keep existing customers.

To promote new products.

To promote slow-moving/declining products.

To reward loyal customers.”


Authors:
These observations are an excerpt  from “Managing Trade Credit for Competitive Advantage” by R Pike, N Cheng and L Chadwick of The Chartered Institute of Management Accountants (CIMA). Visit http://www.cimaglobal.com or write to financialmanagement@cimaglobal.com to obtain a copy of the full report.  

Editor: Ron Wells


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Last Updated:  January 02, 2017 17:19 -0000