These are big figures, but what exactly do they mean?
Trade Credit Explained
The £327bn trade credit figure essentially means that businesses have borrowed £327bn from each other in buying goods, services, raw materials etc. from those businesses. It’s normal practice for businesses to buy on credit terms from each other. In a very similar way, you and I use our consumer credit cards to buy items without any money leaving our bank account at the time. Then, we (ideally!) pay the card off at the end of the month before the interest charges kick in. We essentially get an interest-free loan to fund our purchases, and businesses do exactly the same in utilising trade credit.
Changing funding sources in the UK
While using trade credit as a funding mechanism is entirely normal, the size of this figure is a little startling.
At £327bn, this figure is 20% higher than bank lending, which means that businesses are now routinely borrowing from one another as a mechanism to fund their operations rather than going to the bank for funding. At a certain level, trade credit is a good source of liquidity as well as a natural outcome of the strict bank lending rules - if businesses are to survive and thrive, the money has to come from somewhere, and it’s now coming from trade credit instead of bank lending.
But, in order to create a thriving economy, the borrowing needs to be paid off in a timely manner for the money to flow. As the 2008 banking crisis has shown, businesses suffer when cash or liquidity dries up. Quite simply they need cash to run their operations, and without it, they starve. In this context, a constriction in money supply is highly detrimental to the economy.
Choking the Money Supply
It’s therefore vital to understand how healthy the current money supply is for UK businesses.
And the answer is that it is worryingly fragile. Trade credit is becoming stagnant; on average, it takes a business in the UK 58 days to pay its suppliers on 30 day terms.
Businesses are now taking nearly twice as long to pay as they agreed that they would. And what we also found that was surprising is that smaller businesses on average take ten days longer than larger businesses to pay their suppliers. The net result is that money is not flowing nearly as freely as it should.
The Danger of Isolationist Thinking
So why is this happening?
Quite simply, businesses have taken a conscious decision to extend payment terms in order to keep cash longer in their own business. However, the rationale is likely to vary between large enterprises and SMEs.
Large enterprises are extending payment terms to reduce, or offset, the cost of short-term lending. Holding onto the additional cash reduces their cost of borrowing, which strengthens their balance sheet. City analysts see this improvement favourably and the share price reacts accordingly.
For SMEs the choice is much starker. Because they cannot get funding from banks, they must take longer to pay suppliers, holding onto vital cash to keep their business alive. Without this cash, they’re unable to pay their staff, buy materials, raw goods etc.
However, in both cases, while these decisions makes perfect sense for individual businesses, the practice has serious potential repercussions for the broader business community and the wider economy. In the long term, the strategy of building up a cash position, beyond ensuring that they have enough liquidity to survive, is inevitably self-defeating.
This approach of large and small businesses alike extending payment terms is not unique to the UK. Much the same strategy in companies can be seen across Europe and the US. So this is much more of a global problem than a local one.
A Way Out of the Money Trap
What’s needed is a way out of the money trap.
Our research showed that if businesses paid just five days earlier, it would release over £29bn of working capital back into the economy. In the short term however, it would be hard for businesses to change their approach to trade credit and payment term extension. They simply feel too vulnerable after the recent recession and the resulting sudden, and largely unexpected constriction in money supply.
While introducing legislation would enforce a change, adding artificial constraints on a market beyond reasonable measures is rarely successful. ‘Nanny State’ is not the right approach here. Instead, we need solutions that solve the requirement for businesses to maintain or build cash positions, and for suppliers to get paid either on time or early enabling cash to flow and the economy to thrive. We need a solution that offers real business value to all parties involved.
Supply Chain Finance: Villain or Savior?
If you boil Supply Chain Finance (SCF) down to its core essentials, it is a way for buying companies to hold onto their money for longer, using third party funding to pay suppliers. And it is a way for suppliers to get paid earlier by receiving this cash. SCF has previously got a bad rap because it has been a painful, largely manual process, which until now, only benefited the largest 50 or so suppliers.
The situation is different now. There are new players emerging like Taulia who enable supplier financing to the whole supplier community using modern technology platforms to automate the process. This automation also makes the process much cheaper meaning that suppliers can get their cash much faster for a much lower discount rate.
The benefits here are huge. Buyers get to hold onto their cash for longer. But for suppliers, this is quite simply a golden opportunity as they get a new source of easy, fast and affordable funding to keep their business going.
So instead of vilifying Supply Chain Finance, we should be looking at it as the key to the money trap, with technology as the democratising force to enable all suppliers to benefit.