Enhancing Business Valuation with Trade Credit

Trade credit involves supplying goods and services to business customers on a deferred payment basis (Wilson,2008) and provides access to capital for firms that are unable to raise it through more traditional channels. The shift from the isolated, traditional practice of credit management toward the more technologically advanced and integrated credit management of today has enabled firms to efficiently maximize investment in profitable-customers and minimize risk. The fast-changing credit management practices has played an important role towards reforming the credit policies, customer relationship management, credit services and marketing tools employed by organization, globally.

Extending trade credit is used as a vital extension of short-term financing and as a strategic tool to improve administrative efficiencies, build trust and enhance business development. However, converting debtors into cash in a cost effective, efficient, dispute free and timely manner is crucial to the financial health of any business. Therefore, organization must engage an effective collection strategy to minimize bad debt, financing costs and collection cost. This involves assessing and understanding customer potential income and their risk , tailoring credit terms to reflect the risk through out the economic cycle, and on converting trade debts into cash flow with certainty while bearing practical cost constraints. In a number of ways, this process helps in boosting current profitability, expected earnings growth and liquidity which are ultimately imperial to driving shareholder value.

The granting of credit can signal to customers that the business has confidence in the quality of goods supplied and wants to establish a long-term relationship. This is beneficial to the firm issuing trade credit as it helps in generating repeat purchase behaviour, signals financial strength and establishes reputation in the mist of competition(Finlay,2010).Additionally, trade credit may allow suppliers to price discriminate using credit when discrimination directly through prices is not legally permissible. For example, a firm may informally revise late payments from some customers without penalty or grant discounts outside of the discount period for favoured customers. There is much scope for flexibility and for treating clients distinctively relying upon their importance, short-term financial circumstances, the opportunity for creating repeat businesses or, of course, the relative bargaining position (Wilson,2014).

Furthermore, trade credit, in itself is, useful in reducing transaction costs and collecting valuable information about customers (Petersen,1997). For example, businesses can reduce fixed cost from the number of invoices, shipment and cash handling and increase sales volume by introducing minimum order quantity restrictions with formal credit terms. Analysing the credit choices of buyers and the operations of their customers through their normal course of business , organizations are able to gather information about when the customers need to be monitored more closely, whether credit terms must be modified, or whether the supply of products should be halted for a particular risky customer (Cuñat, 2012).

Finally, credit management can be out-sourced to specialised institutions that perform the various credit administration functions. These include factoring services to a form of advance against a company’s trade receivables and collect outstanding balances on behalf of the company, credit insurance to provide effective means of alleviating late payment problems for example trade credit insurers provided SME's with cover worth up to £25.7 million for goods supplied to Phones 4u whe it was put into administration in 2014, improving credit management discipline and protecting against protracted default or bad debt and credit reference agencies to provide information on potential customers to aid organizations in deciding who is creditworthy and who is not based on credit scoring and judgmental decision rule.