Small-scale businesses, that is the foundation of the U.S. economy, have been difficult for a long time.
However, they’ve also been the most hit by the Great Recession, losing 40 percent more jobs than the other private sector.
It’s interesting because my work in collaboration with Harvard’s Ramana Nanda indicates that there’s an easy method to help small enterprises increase their profitability, attract more employees, and pay them more promptly.
A significant source of financing
If a business has not been paid for several weeks following the sale, it is actually providing short-term funding to its customers, a process known as “trade credit.” This is reflected in the balance sheet as accounts payable.
In spite of its importance for economics and importance, trade credit has not received much attention in academic research until now; in comparison with other forms of finance, however, it is the largest source of finance in the U.S. economy. Trade credit is reflected on companies’ financial statements by the name of “trade payables” in the portion of the balance sheet. According to the Federal Fund Flows report, trade payables totaled up to US$2.1 trillion on non-financial firms’ balance sheets as of the final quarter of 2006. This is two times greater than bank loans and three times more than the short-term debt instrument referred to by the name commercial paper.
News reports have brought attention to the issue of delays in payments to suppliers as large companies increase their payment terms frequently, which can be devastating for small companies.
Some countries have also attempted to overhaul the credit market for trade and have made efforts to reform the need for trade credit, particularly in Europe, where a directive was enacted in 2011 that limited the period of intercompany payments in all sectors by 60 days (with certain exceptions).
In an earlier article, I showed that requiring that payments be made in shorter time durations had a major impact on the survival of small businesses when it was introduced in France. Being able to receive their money earlier helped them to be less likely to default on their suppliers as well as their lenders. The likelihood of going bankrupt decreased by about one quarter.
To find out more about the effect of these changes within the U.S., we looked at the consequences of accelerating the payment process for federal contractors.
QuickPay reform was announced on September 11, 2011. QuickPay change, which was first announced in September of 2011, has accelerated payments by the government of America to a smaller subset of small-business contractors in the U.S., shrinking the time for price by 30 days to just 15 days, which accelerated the federal government’s annual $64 billion contract value.
Federal procurement by the government totals four percent of U.S. gross domestic product. It comprises $100 billion worth of products and services that are purchased directly from small-scale businesses that span nearly every state and industry within the U.S. In the past, contracts for the government demanded payment between one and two months after approval of the invoice, and the result was that small enterprises were providing loans to the government and, often, they also had to use banks as a source of funding for their pay and working capital.
Our research has shown that minor improvements in cash collection can have huge immediate effects on hiring because of work capital’s multiplier effects. On average, each increased dollar of cash flow resulted in a 10-cent increase in the cost of payroll. Two-thirds of that growth came from new employees and the rest from higher wages per worker. In total, the new policy, which has accelerated payments of $64 billion, raised annual wages by $6 billion. It also added just under 75,000 new jobs over three years after the reform.
To illustrate, consider a company that sells $1 million over the year to customers and receives payment for 30 days after the delivery of its product. This means that it must pay for 30 days in sales each day at any one moment (or 8.5% of the total sales). In the end, it has around $80,000 in cash in accounts payable.
A change in the payment system between 30 and 15 days implies that the business is required to finance just fifteen days’ worth of revenue, which is $40,000. In turn, this would aid it in sustaining the annual sales of $2 million and double its size.
Holding back growth
These findings support the widespread belief of business owners and policymakers that payment terms with long repayment periods slow the growth of small businesses.
It also raises the question of why the economy is dependent heavily on trade credit when it is so costly in terms of job creation, and other measures could be put in place to decrease the cost. A fascinating follow-up in the wake of QuickPay has been the SupplierPay. In that program, more than 40 companies, including Apple, AT&T, CVS, Johnson & Johnson, and Toyota, committed to paying their suppliers with speedier payments or providing a financing option that allows them to gain access to working capital at a lower price.
More details about the quality of customers’ services and speed of payments may enable suppliers to decide whether they want to collaborate with businesses that pay less quickly. Therefore, following the “name and shame” logic, companies might think they need to speed up their payments so that they don’t come across as poor customers.
The larger impact
Would it be sensible to continue and extend this policy?
One interesting aspect of our study is that the result of QuickPay is dependent on the local labor market. The most noticeable effect was seen in areas with high unemployment at the time it was implemented. On other sites visited, job growth is limited.
The reason behind this is that helping small companies expand gives them an edge over local businesses. Through hiring more employees, small-scale business contractors make it more difficult for other companies to grow. In the absence of unemployment, this effect of crowding out reduces the gains in employment from the policy.
So, this policy can result in a rise in total employment, but only in regions or periods with high unemployment.