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