This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
If an enterprise is paying cash for everything it buys and is selling on credit, it will obviously need a working capital sufficient to purchase outright its entire stock of goods, including everything that has been sold but not yet paid for. On the other hand, if the enterprise is able to buy on long credit and sell for cash, it can provide its whole stock with no immediate outlay and will pay its bills as they mature out of receipts from its own sales. Ordinarily, neither one of these extreme arrangements prevails. Goods are both bought and sold, at least in part, on a credit basis.
The tendency within the United States, however, during the last two or three decades has been strongly toward reducing the length of credit available to purchasers of raw materials and of goods for resale. This reduction in the period of credit has been brought about, not by an apparent exercise of pressure, but by granting special "concessions" to those who were able to pay cash or to pay within 10 to 30 days. Gradually, as these concessions have come to be more and more accepted, the competition among retailers has made it more and more necessary that they should be accepted. Moreover, the increasing tendency in this direction has now made it the custom in many lines of business to purchase for cash or on short time, and has therefore placed the sellers of merchant dise in a position to insist upon prompt payment.
In retail stores, for example, forty years ago it was not uncommon, nor was it considered improper, for a retail merchant to purchase a line of goods on six months' time. Sometimes he was compelled to ask for further extensions. A little later some of the wholesalers who felt the need of more available cash in their own business began to offer liberal discounts for payment within 30 to 60 or 90 days; and well-to-do retail merchants gladly took advantage of these discounts. Other merchants, as will be more fully explained later on in this chapter, saw the advantage to themselves of borrowing from their local banks at fairly low rates of interest, thus securing funds with which they could take advantage of the discounts offered to them. After this custom became firmly established, the wholesalers began to expect prompt payment and, although the terms were still nominally three months to six months with a discount for anticipating payment, the wholesaler based his calculations on the cash price and the so-called "discount" came to be more and more in the nature of a penalty imposed upon those who failed to pay their bills within 10 to 30 days. So well understood is this custom at the present time, that a merchant who fails to take advantage of the cash discount offered to him is soon looked upon with suspicion.
* Bulletin of the Bureau of Business Research. Harvard University, No. 1, May, 1913, p. 14.
Any so-called discount which is far in excess of customary rates of interest is to be regarded as a penalty for non-payment of bills rather than as an incentive to prompt payment. A striking example is the custom among periodicals of rendering bills for advertising space nominally payable within 30 days, but with a discount of 2 to 5% for payment within 10 days. Inasmuch as these bills are customarily rendered before the issue containing the advertisement is actually ready for distribution, the publisher usually receives his payment in advance of any service that he has rendered to the advertiser. Doubtless the custom arose out of the danger that advertising space may be lightly ordered by concerns which have little real use for it or are unable to pay for it; hence the publisher feels justified in practically demanding - through the medium of abnormal discount rates - that payment be made in advance.
In the "capital-poor" countries in which industry and trade are constantly tending to expand more rapidly than adequate capital for developing them can be obtained, the custom of granting long terms to purchasers for manufacture or resale, which formerly prevailed in this country, continues to exist. In Argentina, for example, it has during recent years been customary for importers and wholesalers of merchandise to sell to the general retailers in the farming districts on 90 to 180 days' time and in addition make liberal provisions for renewal of the retailer's obligations. In turn, the retailer customarily sold goods to the farmers and others in his district on similar long terms. Frequently, the retailer was able to go a step further and actually make advances to his customers in order to enable them to carry on their farming operations and harvest their crops. Each year as the crops were brought to the market and sold, the farmers were able to repay the merchants for all the advances and the goods they had received during the preceding several months, and the retail merchant was then in position to settle his obligations to the wholesaler, who in turn was able to clear up his obligations. Under this system the importer and wholesaler were "carried" in part by the manufacturers - chiefly in foreign countries - from whom they purchased; the retailers were "carried" by the wholesale dealers; and the farmers and other consumers of goods were "carried" by the retail merchants. In years when the crops were good, the harvest months were a period of rejoicing and realization of good profits on the part of every one. When the crops were bad, the entire structure of mercantile credit was shaken and a large proportion of the weaker concerns inevitably went to the wall.
In European countries the general custom prevails of accompanying invoices for shipments of goods with drafts drawn on the purchaser usually for 30 or 60 days.. After receiving the goods and satisfying himself that they are in good condition, the purchaser "accepts" the draft which then becomes an obligation on his part of the same general character as if he had given a promissory note. The "accepted" draft may be discounted by the house which sold the goods, at its own bank or may even be sold in the open market. At any rate, the seller of the goods quickly and easily collects payment, while the purchaser of the goods has an opportunity to adjust his affairs, knowing that he will be called upon to meet his accepted draft on a given day. This system is claimed by many bankers to have noteworthy advantages over the custom which prevails in the United States of persuading the retailer through the use of penalty discounts to pay cash for his purchases.
The system prevailing in this country is made possible only by the existence of great numbers of local banks. The local merchant is in position to borrow from these banks and thus to take upon his own shoulders the whole burden of financing his purchases of goods, whereas in other countries the seller of the goods, either through his own resources or through his banking connections, attends to the financing of the transaction. The same custom has not as yet come to prevail when the manufacturers are the purchasers of goods. Ordinarily they buy on 30 to 90 days' time, or in case of special and exclusive contracts often on longer time. It is usual, however, when accounts run for longer than two to four months, for the purchaser to give in payment his promissory note which the seller may then discount at his own bank. The tendency is strong even here to reduce the period of credit and through the offer of discounts to bring pressure to bear for the prompt cash payment of accounts. Unless some contrary tendency should make itself felt, we may reasonably expect, as time goes on, to see the burden of financing dealings in raw materials, as well as in finished products, assumed to a greater and greater extent by the purchaser.
The effect of this tendency on working capital is self-evident. When the purchases of a firm are made on long-term credits and money is collected from sales before the corresponding obligations fall due, working capital is required only to take care of emergencies. But when the purchaser undertakes to pay cash, he must either possess so much working capital that he can make payment out of his own resources, or at least he must possess enough to provide a margin of safety which will enable him to borrow from banks without question and on favorable terms. The shorter the period of credit that is customarily used by a firm in making purchases, the larger must be the working capital of the firm.