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TRADE CREDIT AND SMALL BUSINESSES: A CAUSE OF BUSINESS FAILURES? Don B. Bradley III and Michael J. Rubach University of Central Arkansas ABSTRACT Trade credit is a major competitive tool for small businesses. However, there are risks in advancing it. The late-payment of trade credit can adversely affect a firm's working capital, which may jeopardize its very existence. This study examines tile association between trade credit and the filing for bankruptcy by 13 1 small businesses. The findings suggest that there is a relationship between poor working capital management and organizational failure. A better understanding of the causes of business failures should assist small business owners, and suggestions for how small business can protect themselves and improve their credit practices are provided. INTRODUCTION Trade credit, the granting to a customer by a supplier of goods or services of a deferral in the time to pay, is a major competitive tool for many small businesses. However there are risks in advancing this type of credit. The late-payment or nonpayment of the trade credit can have an adverse effect on a firm's working capital, which may jeopardize its very existence. floor working capital or accounts receivable collection management has been identified by researchers as a cause of small business failures. There has been little research, especially of smaller firms, addressing trade credit, credit management and the effects of late or non-payment of commercial debt (Peel, Wilson & Howorth 2000). This study examines the association between trade

credit and the filing for bankruptcy by 131 small businesses. The findings suggest that there is a relationship between poor working capital management and organizational failure. A better understanding of the causes of business failures should assist small business owners, and suggestions for small business owners on how to protect themselves and improve their credit practices are provided. TRADE CREDIT Trade credit is offering goods or services for sale with a deferred payment, which grants the buying small business time to pay. There may, or may not, be a penalty imposed (i.e., the charge of interest) if the buyer does not make payment by the Permitted deadline. Most inter-firm sales are made on credit terms and trade credit is an important source of funding for small businesses (Mian & Smith, 1992). The stocks and flows of trade credit can far exceed the size of those for bank credit, typically twice as much, and trade debt is often a major asset for many businesses, often representing a third or more of their total assets (Peel, Wilson & Howorth, 2000). For many firms, supplying trade credit is an important competitive tool which can create new business, build stronger supplier-customer relations, signal product quality, financial health, and image, and differentiate their products or services (Peel, Wilson & Howorth, 2000). A survey of small business finances gathered from a 1998 sample of 3,561 representative U.S. small businesses indicated that 60% of small businesses surveyed used trade credit. Trade

credit use exceeded the use of all other types of financial services except checking. The use of trade credit was most prevalent in manufacturing, construction and tertiary (whole and retail trade) industries, where physical capital is relatively high. Its use \\as less prevalent in industries where human capital costs are higher, such as business and professional services (Bitler, Robb, & Wolken, 2001) An important aspect of trade credit is its dual nature: most companies use both trade credit as customers and supply trade credit as suppliers. Late payment or nonpayment it by customers will require an increase in working capital by the credit supplier. The needed capital call be obtained from four sources: increased debt, increased equity, decreased future investment, or increased credit from suppliers (either in amount or in length of time) (Crittenden & Bragg, 1997). If a firm is forced to balance its working capital, then it will likely delay its payments to its suppliers. For these businesses the net credit position is often critical. Small and growing businesses, subjected to the liability of smallness, are generally less liquid, exhibit more volatile cash flows and profits, and rely on shortterm debt funding (Peel, Wilson & Howorth, 2000). Given these liabilities, efficient credit management of working capital and good credit management practices have been identified as necessary, to the financial health and survival of small businesses (Peel & Wilson, 1996). However, for many firms supplying and financing trade credit may he costly and difficult. WORKING CAPITAL MANAGEMENT For small and growing businesses, working capital management is vital to their success and survival (Peel, Wilson & Howorth, 2000). Successful overall financial

management encompasses both cash flow and cash conversion cycle management, and this is particularly true for small businesses, which often rely on short-term sources of finance (Dodge, Fullerton & Robbins, 1994). Protection from non-payment There are numerous ways for small businesses to improve their receivables collections. Executing financing agreement,, and filing financing statements will insure secured creditor status. Sophisticated credit analysis tools are also available. Small businesses., under the liability of smallness, often do not have either the financial or human capital to utilize these alternatives. Less costly alternatives include: 1. Verify customer information through initial credit applications and constant updating. 2. Communicate clearly the terms of sale. 3. Be diligent in collecting over due accounts. 4. Use a bank- lockbox. 5. Outsource collection functions if you do not have sufficient staff, 6. Take full advantage of legal rights, including enforcement of any lien rights and had check laws. 7. Have set rules in the extending of credit in the first place, and 8. Join credit groups and exchange credit histories (see Tillesen, 1997). Generally a trade creditor of an Insolvent buyer is an unsecured creditor under the Bankruptcy Code. The trade creditor's claim is subordinate to the claims of the Bankruptcy Trustee, and the creditor is entitled to share in the bankrupt's estate only after the payment of senior priority claims (Nathan, 1996). As unsecured

creditors, trade creditors can expect to receive only a fraction of their claims and often only after a protracted court case. However, there is a remedy available to a trade creditor if the creditor advances products to an insolvent buyer. The trade creditor may be able to reclaim the goods delivered to the buyer. Reclamation rights. The UCC and the Bankruptcy Code provide a remedy for a trade creditor that advances goods to an insolvent customer. There are four general requirements (Nathan, 1998: 1996): 1. Send a written reclamation demand to the buyer (either before ten days after the buyer's receipt of the goods, or before twenty days after the buyer's receipt of the goods if the buyer received the goods within ten days of the filing of the buyer's bankruptcy position. 2. The sale must have been on credit and in the ordinary course of business. 3. The buyer must have been insolvent when the buyer received the goods. 4. The buyer must have possession of the goods when the reclamation letter is received. If the trade credit satisfies these requirements, then they may receive payment for the goods, the goods back, be granted a security interest in other assets of the customer, or receive a priority claim in the customer's bankruptcy estate. BUSINESS FAILURES Working capital management, including the prevention of the late payment or nonpayment of trade credit, is a function, which may be critical to the success or failure of the small business. There is an

extensive body of research, which has examined the causes of the failures of businesses (Bradley & Rubach, 2001; Gaskill, Van Auken & Manning, 1993). The research suggests that poor financial management is a major cause of business failure (Argenti, 1976; Peterson, Kozmetsky & Ridgway, 1993 ~ Berryman, 1993 -, Richardson, Newanko & Richardson, 1994). The owners also often lack specific business skills, including capabilities in finance (Shonesy & Gulbro, 1998). Managerial inadequacy, incompetence, inefficiency and inexperience are common themes in explaining small business failures (Haswell & Holmes, 1989). Bad management skills include accounting knowledge, limited access to necessary information to make decisions, and lack of effective managerial advice. Bankruptcy as a business failure There is no consensus on a definition of organizational death or failure (Bruno & Leidecker, 1988). Organizational failure occurs when the organization stops performing those functions which are expected of it (Sheppard, 1994). While there are other manifestations of organizational failure, the filing of a bankruptcy petition (Chapter 7, 11, or 13) reveals the failure of an organization and bankruptcy is recognized as a manifestation that an organization is no longer functioning properly (Sheppard, 1994). Bankruptcy filings, although reflective of only a portion of business failures, do provide a public record of a firm's demise. The demise of the organization is chronicled, allowing for the contemporaneous study of the causes for its failure. Ineffective working capital management, especially the extension of trade credit and its nonpayment, has been identified as a cause for business failure.

The previous discussions raise the following research questions: 1. Is there an association between nonpayment of trade-credit and bankruptcy filings? 2. Has the non-payment of trade credit replaced non-payment of consumer credit as a cause of organizational failure? METHODOLOGY This study examines the causes for business failures as evidenced by the filing of a bankruptcy petition. The data was derived from a questionnaire sent to a random sample of small businesses that had filed for bankruptcy in the fifth and eighth circuits. These circuits generally encompass the center of the United States from the Gulf of Mexico to the Canadian border. The addresses for the businesses were obtained from Bankruptcy Court records and 500 businesses were mailed the questionnaire. Completed, useable surveys were received from 131 small business owners a response rate of 26.2 percent. Effect of trade credit As Table I indicates, 66% of the responding businesses were ere affected by the non-payment by trade creditors. The advancement of trade credit in business-tobusiness transactions was felt by the responding businesses to have a major impact on their businesses. This supports the contention that non-payment of trade credit is a cause of business failure and that effective account; receivable management may be vital to a small business's success and ultimate survival.

Table 1: Businesses Affected by Nonpayment of Trade Credit #* %** Suppliers Going Bankrupt Had an Adverse Effect Great Effect 87 66 Not Much Effect 25 19 None 9 7 Very Little Effect 1 8 *=total number of responses is 13 1 **=equals 100% Effect of consumer credit As Table 2 indicates, 59 percent of the respondents felt that consumer credit sales did not create any problems for their businesses. Thirty-nine percent of the responding owners felt consumer credit had a minimal effect. Thus, 97% of the responding owners felt consumer credit did not have an adverse effect on their business. The increased use of credit/debit cards has apparently reduced consumer credit as a major concern for small business owners and their survival. Table 2: Businesses Affected by Non-payment of Consumer Credit #* %** Consumer credit was a Problem for the Business Very Little Problem 51 39 None 76 58 Large Problem 4 3 *=total number of responses is 131 **=equals 100% DISCUSSION OF RESULTS This research sought to answer the question of whether the advancement of trade credit and subsequent problems with

its collection were a cause of small business bankruptcies. The results support the notion that the non-payment of trade credit adverse] affects small business operations. Further, in answer to the second research question, business-to-business credit transactions, not consumer credit, are perceived by small business owner/operators who have filed for bankruptcy to have a major adverse effect on their operations and survivability. Recent changes in external environment may only exacerbate the effects of the late payment or non-payment of trade credit. The emergence of E-commerce as a business model for small businesses may increase the burden upon small businesses to provide trade credit (Nicolle, 2000). Further, economic downturns may exacerbate the risks inherent in extending trade credit (Schmidt, 2001). While receivables portfolio diversification is desirable, many firms may not be able to change their business plans to reduce receivables risks. However, as previously identified, there are numerous tools and techniques available to small businesses to improve the collection of their receivables. The difficulties in locating former business operators and gathering the historic data necessitated the use of bankruptcy filings. This methodology has its limitations. The data for this study was collected through surveys of businesses located in a number of states located in the center of the I United States. It examines only firms which actually filed for bankruptcy. Organizational failure also occurs through the mere discontinuance of a business - the ceasing of its operations for any reasonDespite this exclusion of some of the population, however, the results have meaning in their identification of the causes for the bankruptcy filings and the reinforcement that nonpayment of trade credit has an effect on the success and survivability of small businesses. Further,

the data has not been fully analyzed. Additional analysis is needed to more clearly discern the associations between the advancement of trade credit and small business bankruptcies. Descriptive data The researchers are providing the readers of this study with the following descriptive data that was as also collected during this research project. The data describes the type of bankruptcy proceeding which was filed; the number of years the small firm was in business; the size of the firm in terms of employees; the person or entity which kept the business' books; the perceived cause for the firm s bankruptcy; and the owner/operator's awareness of potential changes to the U.S. Bankruptcy Code. This data will be evaluated in further papers to be completed at a later date. Hopefully, by providing this raw data it will help the reader understand the credit issues in more detail by knowing more of the descriptive responses of the respondents. Table 3. DESCRIPTIVE DATA #* %** Type of Bankruptcy Filed Chapter 7 74 57 Chapter 11 11 8 Chapter 13 46 35 Years in Business Less than 1 year 1 year 2 years 3 years 4 years More than 4 years

#* 8 20 47 21 11 24

%** 6 15 36 16 9 19

Number of Employees Zero 1-4 5-9 10-14 15 and over Bookkeeping Owner/Operator Family Member Employee Outside Bookkeeper Accountant

#*

%**

25 44 16 9 37

19 34 12 7 28

#* 84 22 4 1

%** 64 17 3 1

20

15

Major Cause for Bankruptcy Non-payment by customer and businesses Law Suits Poor Sales No Major Cause Identified

supports the theory and prior research, which have identified poor work-Ing capital management as a cause of business failure. Its contribution is that it demonstrates that trade credit, not consumer credit, may be a major factor in organizational failure. As the business environments change, future research should examine the effects of trade credit on small business success and survivability. This research suggests that the movement of small businesses into the use of credit and debit cards has virtually eliminated many of the problems previously associated with consumer credit. REFERENCES

#*

%**

40

31

11 37 43

8 28 33

#* %** Awareness of Potential Changes in Bankruptcy Laws Very Aware 53 40 Somewhat Aware 39 29 No Awareness 40 31 *= total number of responses is 131 ** = equals 100% CONCLUSION Many factors, both internal and external, lead to small business failures. This study identifies the nonpayment of trade credit as a major factor. Ideally, we can ]cam from the mistakes of others. For small business owners and operators, the lack of effective working capital management tools and techniques can have adverse effects and jeopardize their survival. Overall, this study

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Dodge, H., Fullerton, S., & Robbins, J. (1994). Stage of organizational life cycle and competition as mediators of problem perception for small businesses. Strategic Management Journal. 15: 121- 1- 134. Gaskill, L. R., Van Auken, H. E. & Manning R. A. (1993). A factor analytic study of the Perceived causes of small business failure. Journal of Small Business Management. 31(4): 18-31. Haswell, S. and Holmes, S. (1998). Estimating the small business failure rate. A reappraisal. Journal of Small Business Management. 27 (July): 68-74. Mian, S. L. & Smith, C. W. (1992). Accounts receivable management policy: Theory and evidence. Journal of Finance 47(1): 169-200. Nathan, B.S. (1999). Sit on your reclamation rights at your own peril. Business Credit 100(4): 8- 10. Nathan, B.S. (1996). Reclaiming seller versus inventory lien holder: Who's on first? Business Credit 98(3): 9-11. Nicolle, L. (2000). Risky Business. Accountancy. 125(1281): 83+. Peel, M.J, & Wilson, N. (1996). Working capital and financial management practices in the small firm sector. International Small Business Journal 14(2): 52-68. Peel, M.J., Wilson, N., & I Howorth, C. (2000). Late payment and credit management in the small Finn sector: Some empirical evidence. International Small Business Journal 18(2): 17-37,

Peterson, R. A., Kozmetsky, G. & Ridgway, ay, N. M. (1993). Perceived causes of small business failures: A research note. American Journal of Small Business. 8(Summer): 1519. Richardson, B., Nwanko, S. & Richardson, S. (1994). 1 Understanding the causes of business failure crises: Generic failure types. Management Decision 32(4): 9-22. Schmidt, D. (2001). Wrestling with a had economy. Business credit, 103(5): 50-53. Sheppard, J. P. (1994). Strategy and bankruptcy: An exploration of organizational death. Journal of Management. 20(4): 795-933. Shonesy, L. B. & Gulbro, R. D. (1998). Small business success: A review of the literature. Presented at the Association of Small Business & Entrepreneurship annual meeting, Dallas, TX Tillesen, S. R. (1997). Ten ways for small businesses to improve their collections. Business Credit. 99(5): 12-14,