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Transcript of Trade Credit and Short
Trade Credit and Short-Term
Financing
Introduction
The current financial crisis highlights the importance of trade credits for
shortrun financing of small and medium-sized enterprises (SMEs). It shows that
evenhealthy SMEs may run out of bank credit and may have to rely on other sources of
short-term financing, like trade credit, to overcome financial constraints orto avoid
bankruptcy. However, trade credit is not only an important source offunding in times of
financial crisis but also in better times. Petersen and Rajan(1997), for instance, state that
trade credit is the single most important sourceof short-term external finance for in the
United States".To date, a number of empirical and theoretical studies analyzed the
demandfor trade credit and the provision of trade credit: With respect to the demand
fortrade credit findings suggest that bank credit constrained forms are more likelyto resort
to trade credit (Biais & Gollier, 1997, Petersen & Rajan, 1997).
In other words trade credit may be used as a source of financing of last resort".With
respect to the provision of trade credit findings suggest that suppliers havebetter
information about the business and the credit risk of their buyers thanbanks or that
having less problems to obtain external finance will overtrade credit to credit constrained
(Schwartz, 1974). Moreover may provide trade credit in order to price discriminate since
lengthening the creditperiod implies a reduction in the effective price. Hence, suppliers
may trade credit to the most price elastic segment of the market e.g. credit
rationed .Moreover, price discriminate because they may have long-term interest inthe
survival of the business partner (Petersen & Rajan, 1997). One might expect,for instance,
that have an incentive to help the business partner with tradecredit if they do not only
take current sales into account but also future growthin sales resulting from a strong
future growth of the business partner.
Theoretical framework
In this section we discuss the relationship between innovation and trade credit.We
first present existing theories on the demand for trade credit and the provisionof trade
credit.Of course, this is not an comprehensive survey since there arevarious theories on
trade credit demand and provision. 1 Instead we refer totheories which are relevant for
deriving the link between innovation and tradecredit.
Demand for trade credit
It is well known that asymmetric information may lead to adverse selection
financial markets (Stiglitz & Weiss, 1981). Firms may receive a smaller loan thanthey
desire at the quoted interest rate or among borrowers some receive loans andothers do not
although they are observationally identical. Emery (1984) arguesthat facing credit
constraints use more trade credit than without creditconstraints. Empirical support for
this hypothesis is reported by Atanasova andWilson (2003), Danielson and Scott (2004)
and Nilsen (2002) who and that creditrationed increase their demand for trade
credit.Furthemore, several studies report empirical evidence for a relationship
between_rm growth rates and the use of trade credit .Cunat (2007) finds that with high
growth rates tend to increase their use oftrade credit relative to other sources of finance in
case of liquidity shocks. Thiscan beexplainedby fast growing need for external finance.
This is in linewith the reported by Howorth and Reber (2003) that fast growing toward
habitual late payment of trade credit. Moreover, the results reportedby Tsuruta (2008)
suggest that with a high level of intangible assets aremore likely to use trade credit than
with low levels of intangible assets.However, as pointed out by Chee K. NG et al. (1999,
p. 1110) trade creditmight be a relatively expensive form of short-term finance. In their
sample themost common form of trade credit is "2/10 net 30"' which is a combination of
a 2percent discount for payment within 10 days and a net period ending on day 30.
Provision of trade credit
We present two theories on trade credit provision which are of special importance
for the link between innovation and the provision of trade credit, namely the_nancing
advantage theory and the price discrimination theory.According to the financing
advantage theory of trade credit suppliers mayhave advantages as compared to financial
institutions, like banks, in offering credit (Schwartz, 1974). Petersen and Rajan (1997) list
three major sources forsuch advantages: advantage in information acquisition, advantage
in controllingthe buyer, and advantage in saving value from existing assets. Having closer
relationship with their customers, suppliers are able to gain information abouttheir
customers in a cheaper way than banks. Moreover, suppliers use di_erentsources of
information than banks do and they are often able to seize deliveredgoods when
customers do not pay. There be an advantage in salving if thesupplier is able to restore
the delivered good before the customer has assimilatedit. Another advantage is that a
supplier can stop delivering goods to its customer.If the customer has no alternative to get
that input, the supplier has the powerto threaten its buyers. Financial institutions like
banks do not have that kind ofpower (Bastos & Pindado, 2007).
Trade credit and innovation
Theory and empirical findings suggest that the demand for trade credit is positively
related to credit constraints. We argue that especially innovative SMEshave a higher
probability of using trade credit. First, innovative are morelikely to be credit constrained
than non-innovative SMEs because banks mayhave problems to scrutinize the value if
assets are mainly intangible.The results of several empirical studies provide empirical
evidence for the hypothesisthat innovative tend to be credit constrained (Guiso, 1998;
Hyytinen& Toivanen, 2005; Ughetto, 2009). Second, small are more likely tobe credit
constrained than large irrespective whether they are innovativeor non-innovative (Beck,
Demirgc-Kunt, & Maksimovic, 2005; Aghion, Fally, &Scarpetta, 2007; Jaramillo,
Schiantarelli, & Weiss, 1996). Therefore we expectthat innovative SMEs have a higher
probability of using trade credit as a sourceof working capital than non-innovative
forms.Moreover, theory and empirical findings suggest that the demand for tradecredit is
positively related to growth. We argue that innovative aremore likely to use trade credit
because they exhibit higher growth rates thannon-innovative forms. Several empirical
studies investigating the link betweeninnovation and growth provide empirical support.
Almus and Nerlinger(1999) and that new technology-based have higher growth rates
comparedto non-innovative ones. Using a quantile regression approach Coad and
Rao(2008) report that beinginnovative is of crucial importance for fast-growing
forms.Roper (1997) finds a positive link between product innovations and output
growthwhile Brouwer, Kleinknecht, and Reijen (1993) report a positive inuence
ofproduct innovation on employment growth. Furthermore, results suggest thatdi_erences
in _rm performance measured as sales per employee can be explainedby innovation
activities. Heshmati and that with a highshare of innovative sales perform better.
Although growth is measured indifferent ways empirical studies point to a positive link
between innovation (e.g.product innovation) and growth. Hence, innovative SMEs tend
to have ahigher probability of using trade credit.
Institutional and macroeconomic effects
Beyond innovation and specific characteristics trade credit provision and
demand for trade credit may be inuenced by institutional and macroeconomicefects. For
instance, Fisman and Love (2003) point out the different role of tradecredit for in
countries with highly developed financial markets and incountries with less developed
financial markets. Moreover, monetary policy andits transmission channels may differ
between countries and this may affect theprovision of trade credit and demand for trade
credit (Nilsen, 2002; Mateut,2005). Atanasova and Wilson (2003) and that restrictive
monetary policy leadsto tighter bank credit constraints and therefore tend to increase the
demand fortrade credit. Empirical studies suggest that industry sffects are also relevant
sincetrade credit is more common in some industries than in others and that there exists a
lot of variation between industries in using tradecredits, but less variation within. In our
empirical analysis we take into accountdi_erences between countries and industries by
controlling for country-specific and industry-specific effects. One might argue, however,
that controlling for unobserved effects is not sufficient. For instance, a positive
relationshipbetween innovation and trade credit may exist in countries with well
developedcapital markets and institutions but may not exist in countries with less
developedcapital markets and institutions or vices versa. Our empirical analysis is based
ona relatively homogeneous sample of 14 European countries which are membersof the
European Union. However, one might still argue that there are sizable differences
between Germany on the hand and transition economies on the otherhand. Therefore, we
allow for diferences between countriesbyrunningseparateregressions for SMEs from
Germany and SMEs from transition economies.
Data Sample
The dataset used in this paper is based on the the World Bank Private Enterprise
Surveys. World Bank enterprise surveys comprise from developingas well as developed
countries. Most in the World Bank survey are smalland medium-sized (SMEs) with less
than 250 employees. Firms are surveyedregarding their perceptions on the major
obstacles to enterrise growth,
the relative importance of various constraints to increasing employment
productivity,and the effects of a country's business environment on its international
competitiveness.
In order to reduce the degree of heterogeneity this study analyzes countries which
were already members of the European Union in 2005 or were inthe process of becoming
members of the EU (Bulgaria and Romania). Moreover,worldwide economic effects
should be similar since all companies were surveyed in2005. Furthermore, this study
focuses on that are more likely to be affectedby financial constraints. All in the sample
have the following characteristics:they are SMEs, the major shareholder of the company
is either an individualor a family, the companies are not publicly listed, no company is
owned by agovernment or a state, the largest shareholder or owner of the is not
adomestic company, a foreign company, a bank or an investment fund. Finally,
not all questions are answered by all and therefore some had to betreated as missing. In
the end, our sample comprises 3869 from 14 countries.
Dependent variable
In the questionnaire are asked about their current sources of working capital and
the corresponding shares in total working capital. Possible sources mentionedin the
questionnaire are, for instance, internal funds or retained earnings, different types of
banks, credit cards or trade credit. Our goal is to investigate the relationship between
innovation and the probability of using trade credit as asource of finance. We generate a
binary variable that takes the value one if a use trade credit and zero otherwise.
Product innovations
The World Bank enterprise survey contains information about product
innovationsduring the last three years. In particular, respond whether theyupgraded an
existing product line or introduced a completely new one. We distinguishbetween which
solely upgraded an existing product line, thatsolely implemented a new product line and
companies that did both. Based onthis classi_cation we generate three product innovation
dummy variables taking.For detailed information about the World Bank .the value one if
a implemented the respective kind of product innovationduring the last three years and
zero otherwise.
Financial constraints
Companies were asked whether access to financing (collateral) or cost of financing
(interest rates) are obstacles for their business. Firms assessed the respectiveobstacle on a
point scale ranging from no obstacle, minor, moderate, majorto a very severe obstacle.
We generate a dummy that takes the value one if reports that one of them is at least a
moderate obstacle and zero otherwise.
Other control variables
To control for several characteristics we include the follog control variables.
The logarithm of employees we use as a proxy for size and logarithmof age. We also add
the variables share of high skilled employees and purchase ofraw material divided by
sales. To control for international integration we includethe variables share of domestic
sales and share of domestic purchases. We use twoother groups of binary variables, one
for the owner status and one for the legalstatus. Within the owner status group we
distinguish between individual andfamily owned. The omitted group is the variable
individual owned .We distinguish between four kinds of legal status, sole proprietorship,
privatelyheld limited company, partnership or cooperative and foreign owner. Here sole
proprietorship is the omitted group. For reasons discussed in a previous sectionwe
include industry and country fixed effects in all models accept the model onlyconsisting
of German , which only includes industry efects.
Descriptive Statistics
It provides the number of the companies of each country and their sharesin the
total sample. Most are from Germany, Poland, Spain, Greece andIreland. The rest of the
SMEs are from Hungary, Romania, Czech, Bulgaria,Estonia, Latvia and Lithuania,
Slovenia and Slovakia.it reports on the distribution of sample SMEs across 20
industries.About 31 % of the SMEs are operating in manufacturing industries. Here the
most frequented industries are Metals, Machinery and Electronics, Garments,Beverages,
Food and Wood and Furniture. Around 69 % are non-manufaturing Hotels and
Restaurants, Transport and Advertising and marketing.
Sources of Finance
There are several sources of finance which might be available to a new start-up
business. These may vary according to the financial standing of the owner and resources
that surround them.It is important to realise that financing of a small business can take
many forms, some of which are more conventional than others. Provided the objective is
borne in mind; that of enabling the operations to afford one or more items, then several
previously unexplored avenues might present themselves as viable solutions.
Friends, Family and Associates
This group of people might be will to lend money to the new venture, particularly in
the light of the existing business have become established over time.There might be some
apprehension concerning the perceived risk of internet trading, but there may well be
some enthusiasm over the prospects of the new business doing well in this
environment.Financing from friends, family and associates is usually on a short term
basis, for periods of one year of less (unless the donor is wealthy).As such, these funds
might be suitable for buying items of stock for resale where a short buying and selling
circle can be predicted and thus ensure that the money is on hand to repay the debt at the
agreed time.Whilst friends and family might be willing to loan money on the basis of
little or no return for their investment, business associates would probably require the
payment of additional amounts, over and above what they originally lent.
This could create additional pressures on the business particularly if the loan is for a few
months instead of for one year or more.In exceptional circumstances, the associate could
request a shareholding and a managerial role in the new venture. This might be welcomed
depending on the business skills processed by the associate and level of need which exists
for their financial backing.
Given that the senior management of the existing business has not been split between
several directors, whether or not such a change in this practice could be accommodated
would have to be considered.
Trade Credit
Credit for trade suppliers could be a useful source of short term financing for the new
venture.Contacts and reputation built up through the existing established business could
be utilised to provide the new venture with credit arrangements which most new
operations could not obtain.Such arrangements and facilities could take the form of a
number of days extended credit of perhaps forty five days instead of the traditional thirty,
a sale or return agreement or perhaps enhanced discounts given the increased overall
quantities which might be sourced from a particular supplier.
Despite having good relationships with others within the industry, it is unlikely that such
contacts could be significant in providing longer term funding required for the premises
or major items of machinery.
Loans from Financial Institutions
Loans from financial institutions such as banks are a common source of funding for
new business ventures.Short term loans and overdrafts might be ideal for the initial
purchases of stock and other working capital requirements such as salaries for selling and
administrative staff.Medium term loans (those ranging from one to five years) might be
used for the purchase of the new equipment assuming that they will remain in operational
use during the term of the loan.The basis here is that as the machinery contributes to the
generation of revenue for the new venture, the repayment of the loan is matched to this
income.Using short term finance for these medium term assets would place the business
under some strain as it sought to pay for items which had not yet had the full opportunity
of generate sufficient income.
The website costs both the initial set-up and ongoing running costs are likely to be
significant. As well as providing detailed information about each car part probably with
photographs, a shopping cart facility will be required.The initial set-up might require
medium term (in this case one to two years) financing as the costs of development,
artwork and hosting may not be recouped within a few months and the website structure
may server the new venture for several years.Ongoing website maintenance costs such as
adding and removing new products and images should most likely be borne out of the
business’ working capital.Long term loans from a bank or other financial institution
would be a suitable course of action should the intension exist to purchase the required
premise outright.Depending on the value and how much is needed to buy the building a
loan of anything from ten to twenty five years might be in line with a prudent and
realistic repayment schedule.
Just as short term finance is generally unsuitable for the purchase of medium to
long life assets, the use of long term borrowing for working capital requirements can
result in the business paying interest on monies which it no longer requires.
Long term loans should therefore be reserved for substantial and long life business
assets.Similar to the aspects of gaining trade credit, approaches made to banks where
existing good relationships already exist might aid the new venture both in terms of
gaining the necessary finance and in terms of securing favourable interest and repayment
terms.
Leasing
Leasing is a frequently used method of gaining use of costly machinery without the
need to buy it outright.Although this method can work out more expensive over time
compared to purchasing the items outright, leasing can provide significant cash flow
benefits as the initial outlay is often small by comparison.Depending on the terms of the
lease, the lessor may be responsible for repairs to the machinery and thus remove this
burden from the new venture.Leasing contacts for machinery usually range from a three
to five year term and hence represent a medium term funding option for the business.
Things to Consider When Using Trade Credit and Supplier
Finance
Trade credit and supplier finance is great for meeting short-run capital needs
quickly and with less red tape than other short term finance instruments.
Cost: Can be high cost. Supplier Terms of 2% Cash Discount within 10 days, net 30
days. By not taking vantage of the Discount, the Company is allowing use of its money
for an additional 20 days at 2%. On an Annualized basis, this is equivalent to a 36%
Interest Rate. Late Payments can run 1-1.5%, monthly basis, which annualized is the
equivalent of 12-18% Interest Rate. If used effectively for short-term needs, the higher
costs attached with Trade Credit can be justified. Over-reliance on Supplier Credit and
using it as an medium or longer term finance need will significantly hamper Cash Flows
and Growth
The Risks: Suppliers can cut off credit at any time or ask you, upfront cash payments
during arduous business periods. A solution could be adopting your Key Supplier as a
small Equity Investor, which promotes more flexible finance terms during cash strapped
periods. The Supplier has a better understanding of your potential upside as an Equity
Investor.
Flexibility Issues: Be careful of Suppliers offering Extended Payment Terms as you can
get locked in or over attached to these suppliers, overshadowing other Suppliers who
offer to a lesser extent prices, a better product and more reliable delivery.
Control: Can lose effective Control of Company Operations if Trade Credit was over-
extended to such a level where your Suppliers take Legal Action, which can result in
attaching Assets and forcing the Company into Receivership.
Availability: This is a short-term need and your short-term Strategic and Cash
Management must be up to the task. Can be significantly curtailed during Economic
downturns; therefore, having a backup Line of Credit is mandatory.
Short-Term Needs: Best utilized for small, short-term needs. Necessary to have
excellent Planning in place to avoid unnecessary costs, such as forfeiting Cash Discounts
or incurrence of Delinquency Fees.
Conclusion
This study contributes to the existing literature by investigating the
relationshipbetween innovation and short-term financing of SMEs. A link that has
beenlargely neglected as yet. It is argued in this study that there is a positive
relationshipbetween product innovation and trade credit. On the hand demandfor trade
credit is related to product innovation since it is likely that innovativeSMEs are credit
constrained and do therefore rely on trade credit as a source ofshort-term finance. On the
other hand suppliers have an incentive to offer tradecredit to innovative SMEs because of
the growth potential of these norms.Our main hypothesis of a positive relationship
between innovation and tradecredit is con_rmed by the our results. In particular, our
results suggest that SMEswhich upgrade an existing product line in the preceding years
are more likely touse (receive) trade credit than other. Somewhat surprisingly the
probabilityof using trade credit is not increased if SMEs solely introduce a completely
newproduct line but do not upgrade an existing product line. One explanation forthis
result are supplier expectations. While suppliers may be able to predict thedemand for
customers' upgraded products it is much more diffcult to predictfuture demand for
completely new product lines. Hence, from the point of viewof the offering trade credit it
may be riskier to provide trade credit to SMEs with completely new products.
Sri Ramakrishna Engineering College(Autonomous Institution Affiliated to Anna University of
Technology Coimbatore)Vattamalaipalayam , NGGO Colony Post
Coimbatore - 641022
Department of Management Studies
Financial Management10DC202
Term Paper
On
Trade Credit and other short term finances
Submitted by
Rajkumar.k1091040
Date of submission :19.04.2011
Marks 10
Signature of the Student Faculty Sign