A note on the price of trade credit

Abstract

PurposeIn contrast to common literature that suggests that trade credit is an extremely expensive source of financing with annual interest rates exceeding 40 percent, this paper seeks to argue that the average interest rate of trade credit does not exceed the cost of alternative funds, thereby explaining why trade credit constitutes a substantial part of the optimal financing mix of large, liquid, and capital market listed firms.Design/methodology/approachBesides providing a formula for estimating a firm's actual trade credit interest rate, this paper is mainly based on a descriptive analysis of trade credit use as well as on survey results of a broad range of prior studies.FindingsThe paper finds that highly liquid firms use substantial amounts of trade credit, thus indicating that trade credit use per se cannot be as expensive as literature supposes. In line, estimated average interest rates are about 4 to 6 percent.Originality/valueBy arguing that actual cost of trade credit use is far from being as high as literature supposes, this paper provides important implications for optimal short‐term financing strategies as well as for the assessment of trade credit use in credit worthiness analyses.

Trade Credit Contracts, Theories and their Applications: A Synthesis of the Literature

“…ative estimation of implicit cost of trade credit and interest cost of bank credit, Fabbri and Klapper (2008) found trade credit to be a cheaper source of working capital. Chludek (2011) estimates the average trade credit interest rates to be between 4-6%, comparable to rates offered by alternative financing sources. Cheng and Pike (2003) show that firm managers in the UK consider trade credit as interest free loans with cash discounts offers and lengthening of credit period being equivalent to price reductions relative to list prices when firms take advantage of the discounts.…”

Assessment of trade credit risk in business companies

“…Dar vienas prekinio kredito privalumas yra tas, kad prekinis kreditas yra gana pigus finansavimo šaltinis. Nepaisant to, kad kai kuriuose finansų vadovėliuose teigiama, jog prekinio kredito palūkanos siekia net 40%, Chludek (2011) argumentuotai įrodo, kad realiai prekinio kredito palūkanos, jei klientas nepasinaudoja ankstyvojo apmokėjo nuolaida, siekia tik apie 5,5-9 %. Negana to, Lietuvoje prekinis kreditas vis dar dažnai yra neatlygintinas ir suteikiamas be jokio užstato.…”

The Issues of the Management of Receivables: Lithuanian Case

“…The analysis of the scientific literature (Chludek 2011;Sokolov, Sokolova 2012;Snieška, Drakšaitė 2013;Boden, Paul 2014) proposes that the following steps should be taken by business companies to prevent the emergence of receivable debts: first, business managers or appointed employees should establish a purchaser's or a seller's identity; second, the method of payment, acceptable to both contract parties, should be confirmed; third, all expenses should be estimated, and scenario matrix should be developed; in the fourth step, potential debt should be evaluated, and debt management measures as well as the possible impact of the debt on a company's financial indicators should be anticipated; in the fifth stage, a contract partner, his reputation and significance to a company's business continuity should be assessed; finally, the decision on risk assumption and transaction execution should be made. Only consideration of all of the steps introduced above ensures an appropriate control of the transaction.…”

“…Brennan et al (1988) Receivables provide an opportunity of price discrimination. However, supplier's credit and assurance of discounts for earlier payment allow to employ this measure Boissay (2004) Receivables determine information asymmetries among companies, suppliers and banks Lamminmaki, Leitch (2011) Receivables refer to a sales policy measure that allows to attract new customers Snieška, Drakšaitė (2013) Receivables allow to reduce transaction costs in case of frequent purchases Owusu-Manu et al (2014) Receivables provide an access to capital for construction contractors globally and is an important source of finance in both developed and developing countries Chludek (2011) Employment of receivables has some cost saving advantages; receivables offer flexibility (by offering the possibility to pay invoices flexibly within a certain time frame, trade credit use improves cash flow synchronisation, in this way reducing the (opportunity) costs of paying and managing invoices); receivables are generally automatically granted at purchase by the supplier's general terms and conditions, so that financing is directly available at purchase, thereby avoiding the transaction costs associated with the procurement of other funds; receivables serve as implicit quality insurance because the customer can inspect the quality of delivered goods or services during the net period, verifying quality before payment. Badu et al (2012) Employment of receivables serves as a financial intermediation device whereby construction vendors act as financial providers to their customers through deferred payments of goods purchased Norvaišienė, Stankevičienė (2012) Receivables promote customers' trust in an enterprise and speak about the ability of this enterprise to operate flexibly Boden, Paul (2014) Managed effectively, receivables can confer competitive advantage in terms of information and signalling, customer relationships and financing of working capital Han et al (2013) Receivables (or trade credits), as one off substitution, give another access to SME finance Nobanee, Abraham (2015) Receivables are used as a sales policy measure; they allow to adjust sensitivity of working capital management to the conditions of market imperfection…”