CHAPTER 8 MANAGING ACCOUNT PAYABLES SREYYA YILMAZ RA

CHAPTER 8 MANAGING ACCOUNT PAYABLES SÜREYYA YILMAZ –RA Working Capital Management 2018

INTRODUCTION • We discussed account receivables management. In this chapter, we move to the other side of the balance sheet and discuss the management of account payables. Just as firms sell their products on credit rather than requiring immediate payment, they usually receive some time to pay their bills due to suppliers; the logic is identical. We now just move one step backward in the value chain. • Thus, purchases of goods and services generate a commercial credit for both the seller (usually a short-term account receivable) and the buyer (usually a short-term account payable).

THE COST OF TRADE CREDIT • It is commonly believed that trade credit does not have a financial cost. This is hardly the case, however (indeed, it is not easy to find examples of any source of capital without an associated implicit or explicit financial cost). • The trade credit condition typically found in the United States is “ 2– 10 Net 30, ” which means that the seller will offer a 2% discount if the buyer pays the invoiced amount within a 10 -day period; otherwise, the full amount is due in 30 days. This implies that the seller charges a premium of 2% for 20 -day credit.

• Doing the appropriate calculations, this implies in turn that the interest rate embedded in such transactions is above 42% per annum, 2 which makes it more obvious that this form of credit is far from being free or even cheap! • This observation raises an interesting question: why would a firm want to use expensive trade credit instead of usually much cheaper financial credit?

• A second set of theories on trade credit relies on the fact that suppliers can do business with a smaller subset of firms than can financial institutions. Suppliers can only trade with firms that are willing to buy their products, whereas a bank can do business with almost every firm and individual in the economy. • Accordingly, in the event of an industry-wide crisis, a bank might choose to restrict credit to the firms in the given industry, while suppliers might be forced to continue trading with, and offering credit to, the firms in that industry, as otherwise they might run out of business partners.

• Being aware of all these issues, buyers tend to be quite strategic in their use of trade credit, and they tend to manage their relationships with suppliers very carefully. In particular, the knowledge that suppliers might provide financing when it is needed most has clear implications for how a firm will set its financing mix during normal times. • To see this, consider a firm that never requires credit from its suppliers but suddenly makes a request for such financing.

• There is a strong possibility that this firm will not get the requested credit. The reason is that the credit request might be perceived to be a signal that the firm is having financial problems, which will affect a nonrelated supplier’s willingness to offer the financing. • Thus, a firm that does not currently need trade credit may nonetheless, include it in its financing mix so as to ensure that the option is available at a later date when it may be needed.

MEASURING TRADE CREDIT AND DIFFERENCES IN THE USE OF TRADE CREDIT • The most sensitive measure of a firm’s use of commercial credit can be expressed as follows: • However, it is quite usual to see this ratio calculated using daily cost of goods sold (CGS) instead of daily purchases, since CGS is commonly available in financial statements, whereas purchases are not always directly observable and hence require additional calculation.

• Using this “alternative” specification (i. e. , using CGS) introduces a bias whose importance depends on the growth in the level of inventory from one period to another. Notice that if initial and final inventories are the same, then there is no difference between CGS and purchases.

• Notice how the use of trade credit varies across industries and over time. The variation in trade credit across industries can be explained by several factors. • Some variation may be related to different patterns between suppliers and clients in different industries. For example, if several firms in a given industry have to buy goods from a single supplier (i. e. , if there is a unique supplier of a given good), it is likely that the supplier will be able to obtain very convenient payment terms; that is, this industry will exhibit high payables.

• Other variations across industries may be explained by differences in the goods’ characteristics. • For instance, things may be substantially different according to whether firms trade commodities or highly customized goods, whether they trade big-ticket versus low-priced goods, and so forth. • The variation in trade credit over time can be explained by macroeconomic conditions that influence the liquidity of the market (see our prior discussion on the role of trade credit during downturns) and the incentive of suppliers to finance their clients.

CONCLUSION • In this chapter, we discussed trade credit from the perspective of the right side of the balance sheet; that is, we focused on the financing that suppliers extend to their clients. Supplier financing is a short-term liability for the buyer. • We showed that relative to other potential sources of short term funding (such as bank loans or commercial paper), trade credit is very expensive. The use of this source of financing can be explained by various theories of trade credit.

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