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Jean-Noel Barrot

Innovation

How Speeding Up Payments to Small Businesses Creates Jobs

Reducing payment times from 30 days to 15 days can have a significant positive effect

Published: Thursday, February 9, 2017 - 12:02

Operating a small business, the backbone of the U.S. economy, has always been tough. But small businesses have been disproportionately hurt by the Great Recession, losing 40 percent more jobs than the rest of the private sector combined. Interestingly, as my research with Harvard’s Ramana Nanda shows, there’s a fairly straightforward way to support small businesses, make them more profitable, and hire more: pay them faster.

A major source of financing

When a business is not paid for weeks after a sale, it is effectively providing short-term financing to its customers, something called “trade credit.” This is recorded in the balance sheet as accounts receivable.

Despite its economic importance, trade credit has received little attention in the academic literature so far, relative to other sources of financing, yet it is a major source of funding for the U.S. economy. The use of trade credit is recorded on companies’ accounting statements as “trade payables” in the liability section of the balance sheet. According to the Federal Fund Flows, trade payables amounted to $2.1 trillion on nonfinancial companies’ balance sheets at the end of the third quarter of 2006, two times more than bank loans and three times as much as a short-term debt instrument known as commercial paper.

Recent news reports have highlighted the problem of slow payments to suppliers as large companies extend their payment periods, often with crushing results for small businesses.

Other countries have tried to reform the trade credit market, especially in Europe, where a directive was adopted in 2011 limiting intercompany payment periods for all sectors to 60 days (with a few exceptions).

In an earlier paper, I showed that requiring payments to be made within shorter time periods had a large effect on small businesses’ survival when it was adopted in France. Receiving their money earlier led them to default less often on their own suppliers and their financiers. Their probability to go bankrupt dropped by a quarter.

Accelerating payments

To learn more about the impact of such reforms in the United States, we studied the effects of speeding up payments to federal contractors.

The QuickPay reform, announced in September 2011, accelerated payments from the federal government to a subset of small business contractors in the United States, shrinking the payment period from 30 days to 15 days—thus accelerating $64 billion in annual federal contract value.

Federal government procurement amounts to 4 percent of U.S. gross domestic product and includes $100 billion in goods and services purchased directly from small businesses, spanning virtually every county and industry in the United States. In the past, government contracts required payment one to two months following the approval of an invoice, with the result that these small businesses were effectively lending to the government—and often while doing so, they had to simultaneously borrow from banks to finance their payroll and working capital.

Our research shows that even small improvements in cash collection can have large direct effects on hiring due to the multiplier effect of working capital. On average, each accelerated dollar of payment led to an almost 10-cent increase in payroll, with two-thirds of the increase coming from new hires and the balance from increased earnings per worker. Collectively, the new policy—which accelerated $64 billion in payments—increased annual payroll by $6 billion and created just over 75,000 jobs in the three years following the reform.

To give an example, take a business selling $1 million throughout the year to its customers and being paid 30 days after delivering its product. It therefore has to finance 30 days’ worth of sales at any given time (or 8% of its annual sales). As a result, it constantly has about $80,000 in cash tied up in accounts receivable.

A shift in the payment regime from 30 days to 15 days means that the firm has to finance only 15 days of sales, or $40,000. And that would in turn help it eventually sustain $2 million in annual sales and double in size.

Holding back growth

These findings confirm the widely shared belief among policymakers and business owners that long payment terms hold back small business growth.

They also raise the question as to why the economy relies so much on trade credit if it costs so much in terms of jobs, and whether other policies might be undertaken to reduce it. An interesting follow-up policy to QuickPay was SupplierPay. In that program, more than 40 companies, including Apple, AT&T, CVS, Johnson & Johnson, and Toyota pledged to pay their small suppliers faster or enable a financing solution that helps them access working capital at a lower cost.

It is likely that more information on customers’ quality and speed of payments would allow suppliers to choose whether to work with businesses that pay more slowly. So following a “name and shame” logic, companies might feel they have to accelerate payments not to be perceived as bad customers.

The broader impact

Would it make sense to sustain and extend this policy?

An interesting aspect of our analysis is that the effect of QuickPay depends on local labor-market conditions. It was most pronounced in areas with high unemployment rates when it was introduced. Elsewhere, job creation was limited.

The reason for this is that helping small businesses grow gives them an advantage over other companies operating locally. By hiring more, these small business contractors make it harder for others to do so. Unless there is unemployment, this crowding-out effect offsets the employment gains of the policy.

As such, such a policy will be effective in stimulating total employment only in areas or times of high unemployment.

This article was originally published on The Conversation. Read the original article.

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About The Author

Jean-Noel Barrot’s picture

Jean-Noel Barrot

Jean-Noël Barrot is the Alfred Henry and Jean Morrison Hayes Career Development Professor and an assistant professor of finance at the MIT Sloan School of Management. Barrot conducts research in corporate finance, with a particular focus on entrepreneurial finance.

Comments

Small business bears the burden of delayed or late payments

Jean

Your article hit home for me and my family. My brother had started a contract manufacturing, precision machining business. He financed the capital equipment with hard earned savings and a note on his home. CNC machine tools are not cheap as many know. He built his business by providing high quality work for a fair, negotiated price. As most entrepeneurs experience, his work week never really stopped. After several years gaining valuable, and valued, customers he began work for a well known aerospace company. (I certainly wish the 'name and shame' idea could come to life). The orders from the aerospace company grew rapidly until it was a significant portion of his revenue. They really liked his work as he was clever and capable of providing certain machined part form factors that were challenging for others. 

In one phone call - it all came crashing down. The big aerospace company called and told him they had to extend payments out to 120 days as they were experiencing a rough financial patch. My brother negotiated, threatened, argued and pleaded as this action would certainly put him out of business and possibly lose his home. They had no empathy or willingness to negotiate and sadly, my brother had to close his business and auction all of the almost new equipment as his cash flow was so severely impacted by their actions. Fortunately, the auction netted enough to pay the notes and clear him financially. He is back to work 'for others' and may not engage in entrepeneurial activities again.

Closing the business meant job losses for a few people, and this was very sad. But it is really larger than that as your article points out. This customers forced payment extension also caused lost rent for the owner of the leased shop space, lost new business opportunity for my brothers suppliers, and lost taxes on wages etc., that would have been paid to the local, state and federal government. 

Yes, it may have been possible to engage with the legal system to seek a remedy. However, the actions of a 'big customer' were so emotionally painful and draining that my brother had little energy left to spend on that. He was fortunate to get a good job almost immediately and moved on.

I support the concepts of improving payment schedules to suppliers, especially small business. We will need to incentivize 'big business' to achieve that. I doubt that being a good corporate citizen will be enough. If we cannot do that, then a 'name and shame' approach may help.

Thank you for a well written article, Jean.