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.
Looking now at dealings in raw materials and merchandise from the seller's point of view, let us consider the effect upon working capital of the customary or average terms of sale. We shall give particular attention to two classes of transactions that were not treated in the preceding section, viz., sales to purchasers in foreign countries and sales by the retailer to the consumer.
So far as dealings between producers and those who purchase for manufacture or resale are concerned, these dealings have been discussed at sufficient length in the preceding pages. It is enough here to state the corollary of the conclusion therein reached, viz., the longer the period of credit which it is necessary to extend in effecting sales, the larger must be the amount of working capital.
There are some special considerations, however, that modify this conclusion in its application to financing sales in foreign countries. These special considerations arise out of the fact that the methods of financing these foreign sales differ somewhat from the method of financing a domestic sale. First of all, the domestic sale is usually on open account; hence, the seller does not come into possession of a piece of commercial paper which he can readily discount. When the terms of credit are longer than two to four months, as has been noted above, the principal may give his promissory note, but it is not the customary type of transaction in this country. In foreign trade, however, the European custom is followed of accompanying the shipments of goods with a draft drawn upon the purchaser. In the South American trade this draft is usually due for payment 90 days after the goods have arrived at their destination; on arrival of the goods it is expected that the purchaser will promptly inspect them and, if they are in accordance with his order, will "accept" the draft which in the meantime will have been forwarded to one of his local banks. Inasmuch as it requires at least a month, or usually more on an average, to secure delivery of shipments from this country to South American countries, and another month is required before funds paid at a South American city can be transferred by mail to a city within the United States, there is an interval of at least five months to be bridged over between the date of shipment and the date of receiving payment - one month for the shipment and draft to reach destination, three months until maturity of the draft, and one month thereafter until payment reaches the shipper in the United States. It should be borne in mind, also, that five months is almost the minimum period. In case it is desirable or necessary to renew the draft, or in case communication requires more than one month, the period before final payment is received may drag out to six or nine months or even more.
If a manufacturer is to build up export trade as an important feature of his business, it is evident that he must either provide a great addition to his working capital or he must have assistance of some kind in financing this export trade.
In the countries which are the chief commercial competitors of the United States - England and Germany - systems of financing foreign sales are worked out in great detail; and this constitutes one of the most important advantages which these countries enjoy in competing with American manufacturers in such markets as those of the Far East and South America. A like system is now in process of formation in this country. It is to be hoped that it will be completely worked out in time to enable American manufacturing exporters to get a firm hold on the trade in competitive markets during the present favorable conditions.
Basically there are five possible methods under which the manufacturer who is making export shipments may quickly realize the cash value of his shipments:
1. He may turn over the financing (with or without the selling) to a firm of commission merchants who agree to pay the manufacturer in cash and to charge a sufficiently higher price to the customer to compensate them for their special knowledge, advances of money, and risk. In some lines, and with the proviso that the right kind of contract is made with commission houses, this may prove to be a satisfactory method.
2. The exporter may carry through his own sales, draw a draft in accordance with the usual custom to accompany the shipment, turn the draft - or bill of exchange as it is more commonly called - over to his local bank to send forward for collection, and on the strength of this increased business secure from his bank an enlarged line of credit. This is very much the same plan that would be followed if the manufacturer were to increase his domestic business. It is usually highly unsatisfactory as a means of financing export shipments, however, because the banker is seldom willing to grant credit for a sufficient length of time, or to a large enough amount, to give the manufacturer all the assistance that he needs. In other words, under this plan it is necessary for the manufacturer largely to increase his working capital in order to handle export trade and this places him at a disadvantage as compared with his foreign competitors.
3. The manufacturer may forward his bills of exchange for collection through his bank, and arrange with the bank to give him an advance up to a fixed percentage of each draft. This percentage may be as low as 50% or as high as 90%, or even 95%. This is certainly a better arrangement both for the manufacturer and for the banker, inasmuch as it gives the manufacturer a larger amount of available credit which varies in direct proportion to his foreign business, and gives the banker a direct collateral of good quality to secure his advances. Until recently it has been the method most widely used within the United States, and is also much used in England and Germany. The chief objection to it is that it does not go far enough, inasmuch as the percentage of safety which the American banker requires is much higher than the percentage customarily required in competitive countries.
4. The exporter may actually "discount" or "sell" his bill of exchange, to a banker who is doing business through a branch or through a closely allied correspondent in the district to which the shipment is going. The bill is usually bought "with recourse," which means that the banker reserves the right to demand payment of the draft from the exporter in case the importer fails to meet it promptly. It is usually discounted at 6%, more or less, with an additional commission charge of perhaps 1/2%. This is, on the whole, a satisfactory method of financing so far as the manufacturer is concerned. He gets his money, minus a reasonable discount and commission charge, at once, and thus is not stripped of working capital. To be sure, a contingent liability remains, but, unless his sales policy is defective in the extreme, there will be very few cases in which his bills go to protest. The chief objection is that the banks of the United States are not, as a rule, sufficiently well represented abroad to carry on this business, so that it is conducted chiefly by agencies of foreign banks in New York City.
5. The exporter may turn over his bill to his bank to forward for collection, and the bank in turn may permit the exporter to draw another draft on the bank, which the bank "accepts." The exporter may then take this "accepted" draft into the open market and sell it for whatever it will bring. Inasmuch as an accepted draft is practically equivalent to a promissory note, those drafts which have been accepted by strong banks, are salable at a very low discount rate. The bank charges a small commission, equivalent to about 1 to 2% per annum, for stamping its acceptance on a draft. Usually the draft drawn on a bank is for 80 to 95% of the amount of the exporter's draft on his customer. This method has been possible in the United States only since the Federal Reserve Act went into effect in November, 1914. It is simple and practical and gives to most exporters the financial assistance that they require. Usually the manufacturer is able, through this method, to get returned at once at least the full amount of the cost to him of manufacturing and selling the goods he is shipping, and is compelled to wait only for his profit on the transaction. That being the case, he may carry on as much export trade as can be financed in this way without direct increase in his working capital.
As was remarked in the preceding section, the English custom is to accompany almost all shipments, domestic as well as foreign, with drafts, which are accepted by the purchasing house and thereupon become a good quality of marketable paper which banks are quite ready to discount. This system enables the manufacturer to borrow large amounts from his banks with safety, and to count upon this borrowing as a permanent source of funds not subject to the more or less arbitrary conditions that bankers find it necessary to impose under the American system. The English manufacturers and trades, therefore, are in position to carry on their business with a much smaller amount of working capital than is required by a business of corresponding volume in this country. Take an example at random: The well-known English firm of Bolckow and Vaughan, manufacturers of iron and steel, carried on a recent balance sheet current assets as follows:
Sundry Debtors (Accounts Receivable)........
The Sundry Creditors (Accounts Payable) were listed at £500,000.
Note the remarkably small amount of cash in proportion to the current assets and liabilities. The fact that so large and prosperous a firm should carry so little cash can be accounted for only as a result of the English practice with regard to financing sales which has just been alluded to. Under this practice it is easy for the manufacturer or trader to realize on his sales and secure whatever cash he needs on short notice.
For this reason it is important that better facilities should be developed in the United States for financing sales abroad and long-term sales within this country. If this were done, and probably it will be done, the amount of working capital required to handle a given volume of business would be much reduced. For the time being, however, and until these facilities are more fully and more efficiently supplied, we must in many cases figure that any increase in sales which is accompanied by a lengthening of the terms of payment will necessarily involve a disproportionate addition to working capital.