Let's return to the leafy campus environs of Premier Law School, where our old friend Alpha has approached his coffee supplier Gamma with a request to purchase an additional bag of coffee on credit.
Alpha has been running his cart for a month, and has been buying a sack of coffee from Gamma every week, using the cash he has collected from the previous six days of sales. Alpha has just overheard his customers talk about a campus open day that is to be held in a couple of days, and he thinks he can sell an entire week's worth of coffee in a single day. He needs an extra bag of ground coffee to cover the anticipated demand.
Should Gamma sell him the coffee on credit? On what terms?
The decision to extend trade credit to a buyer
Gamma is not a banker. Indeed, he has seldom set foot in a bank, preferring instead to handle his affairs outside the formal economy. But he finds himself now in the role of a de facto loan officer, deciding whether to extend credit to a small business owner. Luckily for him, the “3 C’s” of lending are intuitive, practical and robust. For those of you who are new to this game, they are Capacity, Character, and Collateral. As a human being, you have plenty of experience with Character, and as a legally trained professional you should know all about Collateral. We will concentrate here on Capacity.
Does the coffee cart generate enough cash to give Gamma comfort?
Let’s look at this from Gamma’s perspective:
Gamma passes Alpha’s coffee cart at least once a day. Alpha has plenty of customers - even at night. At peak hours there is even a small line. Alpha charges 10 bizcoins per cup. Gamma estimates sales of 100 cups per day, and hence revenues of 1,000 bizcoins per day, or 7,000 a week.
Gamma sells Alpha one bag a week at 1000 bizcoins per bag. Assuming Alpha uses up the whole bag, that’s 700 cups from a bag or about 1.1 bizcoins of coffee per cup (if you look back at the post on gross margin and unit economics, you’ll see it’s a pretty decent estimate!) Having tasted the coffee himself, he knows that Alpha is similarly frugal with the other main ingredients, so he guesses that Alpha is generating margins of 50%. A business that generates revenue of 7,000 bizcoins a week with margins of 50% will have 3,500 bizcoins at the end of the week in gross profit.
But will this cash actually be available? What if Alpha has been extending credit to the students who are his customers? Here, Gamma takes comfort in the fact that the surge in demand will be made up of prospective students from out of town, and these customers will have to pay cash.
Sounds promising. What would sensible terms of trade be for Gamma? 1 bag, on credit for 1 week, at a price of 1,020 bizcoins rather than the usual price of 1,000, seems like the right way to compensate himself for the risk, and for the time value of the cash he would have received.
From trade credit to a bank loan
Here's the beautiful thing. If Alpha does pay Gamma next week, on time and in full, then guess what? Gamma will be a little more willing to start letting Alpha pay for his regular bag of coffee with a week's delay. And as the quanities increase and the relationship deepens, Gamma will become comfortable with more generous credit terms.
At some point, Gamma may even get a call from a bank where Alpha has applied for his first business loan, and the credit he extends to the coffee cart will be factored into the bank’s decision to make that loan.
The development of credit chains
As Gamma begins to extend trade credit more often to Alpha, and at more generous terms, he may find that his own cash balance tends to be lower than he likes. He may in turn ask his wholesalers in the city to extend some trade credit to him. And so a chain of trade credit starts to form.
A utopia?
The fairy tale I have told you takes place in a reasonably healthy business environment where credit flows freely, business confidence is high, behaviours are observable and verifiable, and customers have money in their pocket. But that’s not always the case. Credit shocks can disrupt confidence, strain relationships and reduce the ability or willingness to extend credit.
The concepts and frameworks I have outlined hold true in bad times as well as in good. When credit is tight, resources scarce and fraud rife, it becomes more important to think carefully and critically about business models, margins, cash flow and creditworthiness. Paradoxically, when times are very good, and when everyone is being encouraged to dream big, and when credit is loose, it becomes becomes even more important to be skeptical, rigorous and a bit of a spoilsport.