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.
The fact that all the trade credit which a business normally utilizes is in fact a method of borrowing capital, seems to be overlooked; yet it is the chief source of capital in many concerns which do a trading business. There are literally tens of thousands of small merchants throughout the country who customarily buy nearly all their stock in trade on credit, and whose own capital is no more than sufficient to cover the purchase of store fixtures and perhaps some small advances on their first orders as a guarantee of their good faith. It is out of the question for them to pay their accounts with the wholesalers from whom they buy, until after they have sold the goods and thus have secured cash funds from their customers. Very often the wholesaler in his turn is "carried" to a great extent by the manufacturers and jobbers from whom he buys; his proportion of owned capital, however, is likely to be much higher than the retailer's proportion. Going one step further back we reach the manufacturer with whom trade credit is comparatively a minor source of funds. Thus we have the whole process of selling goods through the ordinary trade channels financed to a considerable extent by the extension of credit. The ultimate customer is the only man in the chain who pays cash - and even the customer may in his turn be living on trade credit. As the customer pays for his purchases, the retailer is able to collect current funds which he transmits to the wholesaler, who in turn pays the manufacturer and jobber.
The extent to which trade credit is granted, depends chiefly upon the nature of the goods that are being retailed, and on the ability of the ultimate consumer to pay promptly. Sometimes extreme instances are found in which a whole community or a whole country is doing business largely on "trade credit." In Argentina, for example, during the several years preceding the beginning of the European War in 1914, all trade was handled on the basis of long credit. The importer of manufactured articles had become accustomed to receiving 90-day drafts (which is the usual term of drafts representing shipments from Europe or the United States to South American countries), and these drafts he was frequently able to renew for a like period; so that the importer was getting three months' to six months' credit on all his purchases. The importer in turn sold to country storekeepers on "open account" and was compelled to wait for his payment until the storekeeper could collect from his customers. The customers were for the most part land owners who had funds only at one season of the year, after the sale of their crops; consequently, the storekeeper was in the habit of securing three months' to nine months' terms for himself. Thus all business was being done on "long credit" and the proportion of owned capital invested in retail, wholesale, and importing houses was abnormally small. By reason of the wonderful resources and prosperity of the country, this system worked fairly well for a number of years and made possible enormous profits in all lines of trade. Its danger was shown, however, when successive poor crops in 1912 and 1913 impaired the paying ability of the Argentine farmer and led to an enormous number of mercantile failures.*
Much the same situation and practices existed in the United States a generation or more back. Prior to the Civil War, purchases of merchandise were customarily settled by notes running six, eight, or ten months and sometimes longer. This was due to the fact that buyers came to market only once or twice a year, and then purchased their entire stock for the season, the buyers giving their notes which were readily indorsed and discounted. These were usually met out of the proceeds of the sale of the goods to the ultimate consumer. The Civil War upset this system. During the war and for some years after, merchandise business came down to a basis of cash or of credit of only ten to thirty days. When the next great expansion of trade took place in the early 80's, the increased confidence of sellers resulted in offering somewhat longer terms of credit, but these terms were combined with offers of liberal discount for cash payments, which is the custom in most lines today. The discounts were so attractive that retail merchants in good standing began to borrow from their local banks in order to take advantage of them. Thus the present practice of taking discount for cash was established; and prices are now made with that understanding. The high rates of discount are now in the nature of a penalty imposed on a merchant who takes the long terms which are nominally at his disposal. This change in custom of payment was accompanied by the introduction of the commercial traveler, selling from sample in comparatively small lots. The process has been helped somewhat by the standardization of goods and selling methods, and the quicker turnover which has now become possible.*
* For a more detailed study of this situation see the authors report on "Financial Developments in South American Countries," issued by the Bureau of Foreign and Domestic Commerce, Washington, D. C.
For these reasons, trade credit in this country is relatively less important, and bank credit is more important, than was formerly the case. Another factor which should be mentioned as contributing powerfully to this result is the decentralized banking system of the United States, which puts one or more local banks at the door of every merchant and makes it comparatively easy for him to secure and utilize bank credit.
The European system of financing merchandise purchases rests upon the use and discounting of accepted drafts which are in effect two-name promissory notes. The wholesaler draws a time draft upon the retailer which accompanies the shipment of goods. The retailer writes or stamps his acceptance on the draft across its face and returns it to the wholesaler who is then in position to discount it with his bank. This is a method of financing merchandise transactions which, from the banker's standpoint, has a number of advantages, the chief of which is that every accepted draft represents an actual transfer of goods, and the banker is not compelled to lend, therefore, merely on the strength of the general credit standing of his customer. An effort is now being made, under the guidance of the Federal Reserve Board, to introduce this system in the United States. Although the movement is of genuine importance, we need not for our purposes consider it further. It is closely similar to the custom which prevails in certain lines of business of giving notes in payment for purchases of merchandise.
Some of the principal lines in which note-giving is still common are harvesting machines, plumbers' supplies, book printing and binding, and electric trolley supplies. In most other lines, however, goods are sold on open account and notes are asked for only when the sale is made to a weak concern. Sellers are often so anxious to dispose of their products, and it is consequently so easy for established firms that have a clean record behind them to secure whatever goods they require on terms of 30 to 90 days or even longer, that trade credit may almost insensibly become a real source of danger. It is a delicate instrument which requires to be handled with watchfulness. A little carelessness in failing to meet trade accounts on the day they fall due may be sufficient to give a concern the reputation of being "slow pay," and thus may damage not only its credit with the firms from which it buys, but also its credit with banks as well as its general business standing.
* See an excellent article entitled "Proposal to Dehumanize Trade," by E. D. Page in New York Annalist, March 16, 1914.
On the other hand, there is undoubtedly such a thing as being overzealous in paying up trade accounts. Not only is there an actual loss of capital to the extent of the difference between a normal amount of trade credit and the amount which the company secures, but there is also to be considered the fact that the habit of paying accounts ahead of time, once it has been formed, cannot be easily broken. The writer has in mind one concern which started in business with ample funds. The treasurer saw no reason why he should utilize the credit of the firm and paid all bills in cash as they were presented, even though he obtained no discount. A year or two later the expansion of the company's business reduced the available cash, and the treasurer began to take the full term of payment to which he was entitled. Immediately some of his creditors became suspicious as to the solvency of the company, and rumors spread about which were so serious that it was necessary to bring more cash into the concern and resume, for the time being at least, the prompt payment of bills. Thereafter the company proceeded by slow degrees to utilize the full line of trade credit to which it was entitled. There is much truth in the remark that the only way to acquire credit is to make use of it.