The mechanism of commercial credit; terms of sale and trade acceptances

Front matter

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Preface

This book is addressed to the business man, the credit man, the banker, and the student.

Men in all lines of business are daily called upon to decide whether they will pay cash for their purchases or instead will buy on credit. Conversely, they themselves are called upon to decide what terms they will offer to those who buy from them. These fundamental questions are all too frequently decided by the average business man without sufficient knowledge of the factors involved, and consequently without regard, in many instances, to the most advantageous and effective credit arrangements. The smaller business man who incidentally handles his own credits is naturally under the greatest handicap, but for those who devote their entire time to serving as credit men in larger houses knowledge of this kind is no less important. In fact, their study of the subject of commercial credit should be much more thorough.

Bankers constantly require a knowledge of credit practices in different lines of business. Furthermore, in granting loans they must continually give consideration to the factors that determine these credit arrangements. In other words, they must have an intimate knowledge of the mechanism of commercial credit and the manner in which it operates. Not only is this true directly for their daily tasks, but from a broader point of view such knowledge is no less necessary in order to enable them to understand the relation of the bank to commercial and industrial life.

Students of business are paying increasing attention to the role that commercial credit plays in the modern busi-

vii viii PREFACE

ness structure, and a growing number of colleges and schools of business are offering courses that, wholly or in part, are devoted to a study of the subject.

The reader will find in this book both a summary of credit practices in leading industries and an analysis of governing principles. "The reason why" need not invariably be difficult to understand, and it is a necessary complement to description of practice. Neither aspect can be neglected. Effort has been made throughout to illustrate the principles by reference to the situation in typical industries.

Equally important with this analysis of the factors at work in the present commercial credit structure is an answer to the questions: How satisfactory is the present system? Should it be modified or supplemented, and if so, how ? This raises the entire question of the trade-acceptance system v. the cash-discount system, which has been in the forefront of discussion for the past five years or more. Every business man, banker, and student must form an opinion on this question. Previous discussion, too, has been largely partisan, and has not clearly indicated the underlying principles. In the present work effort has been to deal with these features in a clear and concise manner, and to indicate as definitely as possible the conclusions to which this analysis must lead.

In preparing the book the writer has drawn upon various sources for his information. The discussion of terms in leading industries in Part III is based upon studies made by him for the Division of Analysis and Research of the Federal Reserve Board, in the course of which data were obtained from a large number of business houses and trade associations. Each section relative to conditions in a particular line has been submitted to an authority in that industry, as indicated at the appropriate places in Part III. Acknowledgment is due to each of the gentlemen there mentioned. The writer is also greatly indebted

PREFACE ix

to Mr. H. W. Strong, secretary of the Strong, Carlisle & Hammond Company, Cleveland ; Mr. Sidney Y. Ball, president of the Norris, Alister-Ball Company, Chicago; and Mr. Philip Hamburger, Jr., treasurer of Henry Sonneborn & Company, Inc., Baltimore, for kindly reading Part I, dealing with the factors governing terms. In connection with Part II, dealing with the trade acceptance, he is indebted to Mr. John S. Jenks, Jr., of Philadelphia, and Mr. W. W. Orr, assistant secretary of the National Association of Credit Men. Their suggestions, while reflecting opposite views of the question, have materially improved the work.

The writer is also greatly indebted to Dr. H. Parker "Willis, Professor of Banking in Columbia University; Dr. Frederick B. Robinson, Dean of the School of Business and Civic Administration of the College of the City of New York; and Dr. George W. Edwards, Assistant Professor of Banking in Columbia University, who have read the entire manuscript and made many helpful suggestions. The opinions expressed in the work, needless to say, are entirely personal, and have no official significance.

W. H. S.

Contents

PAGE

Meaning of terms of sale 3

Getting working capital 4

Part I Factors Governing Terms

II. Length of Net Terms 17

The fundamental factor 17

Nature of the article 19

"Pay-day" terms 22

Customary settlement dates 24

Geography of terms 24

Terms on manufacturers' raw materials ... 25

Terms on fixed capital goods 26

Carrying the purchaser 27

Terms in retail trade 29

The marketing period in relation to the bank . 29

The marketing system 30

Some illustrations 31

The wholesaler's credit function 34

Manufacturers' and wholesalers' terms ... 35

III. Length or Net Terms (Continued) 38

General competitive conditions 38

Relative size of buyer and seller 39

Competition or concentration among buyers and

sellers 39

Cash outlay, profits margin and capital position of

the seller 42

Trade-marked goods 44

Regularity of relationship between buyer and seller 45 xi xii CONTENTS

PAGE

Business character of each 47

General illustrations . 47

Mutual interrelation of terms 50

Terms of the individual house 52

How the net period is covered , 53

IV. Datings 56

Season datings 56

Advantages to the seller 57

Illustrations 59

One-season industries 60

Frequency of purchases 62

Indirect datings 63

Shipments to distant territories 64

Competitive or extra datings 65

Datings not rigid 66

Grouping of transactions 67

V. Cash Discounts 69

Cash discounts and trade discounts .... 69

Nature of the cash discount ....... 71

Relation to terms 72

Function 73

Length of the cash-discount period 75

Methods of quoting 76

Size of the discount 78

The credit risk 79

Position of the seller 80

Net terms 81

Low discounts 82

High or competitive discounts 83

Department store discounts 84

Graded discounts 84

Anticipation rates and past-due rates .... 86

VI. Terms in Relation to Business Conditions . . 88

The business cycle 88

Terms and general business conditions ... 89

Movement of terms in particular industries . . 91

Discounts and business conditions 92

Wartime changes 94

Types of changes 95

The tendency to shorten terms 98

The movement to standardize terms .... 101

Wholesalers' interest in terms 103

Buying and selling terms of wholesalers . . .106

CONTENTS xiii

Part II The Trade Acceptance Question Page

VII. The Trade Acceptance Movement in the United

States 113

Meaning of the trade acceptance 113

The trade acceptance before and after the Civil

War 114

The trade acceptance and the Federal Reserve Act 115

Work of the Federal Reserve Board .... 117 The trade acceptance movement — the National

Association of Credit Men 120

The American Trade Acceptance Council . . . 122

Work of the bankers 124

The American Acceptance Council 126

Trade associations and the trade acceptance . . 128

Opposition to the trade acceptance 130

The post-war period 133

Trade acceptances at Federal Reserve Banks . 136

VIII. Extent of Use op Trade Acceptance .... 139

Surveys of the use of the acceptance .... 140

The Federal Reserve Board inquiry of 1917 . . 141

Inquiries of trade-acceptance advocates in 1918 . 143

Investigation of Messrs. Paine and Jenks . . 144

Survey of 1918 147

Investigation of Park Mathewson in 1921 . . 148

Present use of the trade acceptance .... 149

IX. The Net- Terms System versus the Cash-Discount System— Credit Aspects .... 153

Alternative systems of finance 153

The net-terms system and the trade-acceptance

system 155

The problems involved 156

Fundamental tests 157

Agency for credit measurement 158

Relative merit of seller and bank 160

Checking of credit by the local bank .... 161

Analysis of types of industries 164

Method of credit measurement by the bank . . 166

Collection of accounts 169

X. The Net-Terms System versus the Cash-Discount System — Social and Banking Aspects 173 Effects upon business practice 173 xiv CONTENTS

PA9B

Composition of the business community . . . 175

Relation of the borrower to the bank .... 176 Automatic elasticity of volume of commercial

paper 177

Effects upon general prices 179

Prices of particular goods 179

The discount market 181

Conclusions 182

Part III Terms Now In Use

XI. The Foodstuffs Industries 187

Meat packing 188

Canning 190

Flour milling 192

Sugar refining 196

Coffee, tea and spices 197

Confectionery 198

Tobacco manufactures 199

Wholesale groceries 200

XII. The Metal Industries 208

Iron and steel . 209

Copper, lead and zinc 211

Hardware 215

Mill supplies and "machinery" 224

Machinery 227

Railway equipment 229

Shipbuilding 230

XIII. The Automotive, Agricultural Implement, Elec-

trical and Fuel Industries 232

Automobiles 233

Rubber goods 237

Automobile accessories 240

Agricultural implements 242

Electrical products 254

Coal and coke 257

Petroleum 262

XIV. The Textile Manufacturing and Dry Goods In-

dustries 268

Cotton 269

Silk 27^

CONTENTS xv

PAGE

Woolen and worsted 279

Hosiery 285

Knit underwear 287

Laces and embroideries 288

Wholesale dry goods 290

Men's wear woolen and worsted jobbing ~ . . . 300

XV. The Appaeel and Leather Industries .... 303

Men's clothing 304

Women's outer garments 309

Fur manufacturing . 314

Millinery 316

Tanning 319

Boots and shoes 325

XVI. The Lumber and Miscellaneous Manufacturing

Industries 331

Lumber 332

Office furniture and store fixtures 338

Paint and varnish 340

Glass and glassware 341

Jewelry 343

Optical merchandise 348

Wood pulp and paper 349

Drugs and Medicines 355

Appendix. Tabular Statement of Terms of

Sale 362

Introduction

The outstanding feature of modern industry is the long period of time between the extraction of raw materials and their final delivery in some useful form to the consumer. Production is not a simple, direct, hand-to-mouth process. It is complex and roundabout. No article is completely produced until it is ready for use by the ultimate consumer. Production consists of a long series of steps, processes or stages and involves many men and operations, many exchanges and bargains, many transfers and handlings of goods. All this takes time. Parallel with this technical phenomenon of production is the financial phenomenon of credit. By credit we mean the accommodation which one concern extends to another when it gives valuable things in the present in return for a claim to be paid or discharged in the future. There is no credit in a barter and no credit in a cash exchange. Credit does not enter where transactions are fully closed in the present.

Meaning of Terms of Sale. — When a buyer receives goods from a seller on condition that he will pay for them in the future, a credit relationship is established. Usually it is established upon some definite basis, and is expressed in the terms of sale which are quoted. Technically, the terms of sale specify the time and general conditions of payment by the buyer. They usually consist of two parts: the one part, a certain period of time, such as 60 days, within which payment of the amount of the bill is due, without being subject to any deduction; the other part, a certain period of time, usually 10 days, for payment within which the deduction of a specified cash discount, such as 2 per cent, is permitted from the amount of the bill. The terms then generally include both cash discount and cash discount period, and net terms. Using the illustrations just cited, they will be quoted, for example, as 2 per cent 10 days, net 60 days.

Certain expressions with respect to terms are usually employed. Terms in each different line of business are relatively uniform, so that certain terms exist in such cases which are recognized as "regular." They may be "recommended" by trade associations in the particular line and stage, and may call for extra time, or what is known as a "dating," in addition to the net terms which would otherwise be quoted.

But terms of sale cannot be considered as isolated matters. They are inextricably interlocked with many other financial and industrial matters. They are intimately related to the financial problems which every business house must face; and they are an integral part of the general credit system. Both of these in turn react upon and influence the banking system. In other words, finance, credit and banking are all closely joined together, and terms of sale provide one of their mainsprings. As a result, terms have many ramifications and raise many collateral questions, relating to various parts of this large field. It is necessary to set them in their broader framework in order to obtain a clear understanding of their real meaning and significance.

Getting Working Capital. — Consider a medium sized or small business man who has issued neither stocks, bonds, nor long term notes, and who does not sell his paper in the open market. In case his own funds are insufficient, he may obtain the working capital which he needs for his ordinary operations in one of two ways. He may either borrow from his bank in order to pay wages and other incidental expenses, and to pay cash for goods which he buys, or else he may buy these goods on time instead. When he does the latter, he owes the man who has sold him the goods, and not the bank. Although credit is granted in both cases, in the one it is commercial credit ; in the other, bank credit.

A great variety of factors determine which of these two courses the individual business man will follow. This is true even of the relative extent to which the same man will use each of them, and buy a part of his goods on time instead of paying cash with funds which he borrows from the bank. In large measure, these factors relate to the peculiar conditions which surround his individual business, but in many ways practice is the same for all those engaged in a certain kind or class of business.

The Commercial Credit System. — Consider now business houses as a whole, instead of the individual business man. Some houses buy for cash and merely owe the bank, while others buy only on time and thus owe other business houses instead. The great majority perhaps do both, and buy to some extent in each way — part for cash and part on time. They likewise sell part for cash and part on time, granting other business houses the option of paying in either way which they themselves are granted when they buy. Each house thus has certain credit relations with other houses. Taken together, these credit relations between the different houses constitute the commercial credit system.

This system is almost as widespread as our entire economic life and economic activity. Through it the tremendous volume of business in modern economic life is made possible. It serves to effect the exchange of these masses of goods — goods which are produced under a system of division of labor wherein each individual and each group of men engage in that occupation for which they are relatively best qualified. The system serves also to bind together the various business houses, and to create among them extensive and intricate interrelations and interdependence. No one can stand alone, but each is intimately related to other houses, so that disaster to one often carries in its wake disaster to many others.

Analysis of the System. — The system is not so complex as it may appear to be at first sight. The fundamental features are relatively simple and there is underlying uniformity in certain directions. The credit relations of certain definite groups of houses are similar, and the system may thus be resolved into several component parts. To do this, it is necessary first to analyze the economic process whereby goods are produced and then moved from maker to ultimate consumer.

The economic process when taken in cross section reveals several distinct stages. Some men are engaged in producing raw materials, either of mineral or agricultural nature ; others fashion these materials into more or less finished articles, which they may in turn resell to still others who further manufacture them. The spinner sells cotton yarn to the cloth manufacturer, who may merely make grey goods and sell them to the converter, who in turn produces finished cloth. Merchants may next purchase this cloth and resell it to retailers, who in turn dispose of it to the final consumer. The extent and number of these stages of course vary greatly. There are middlemen who deal in various agricultural products, while articles serving as producers' goods, such as machinery, are often sold direct by manufacturers to those who use them as part of their plant equipment. On the whole, however, the major stages are quite clearly defined for any one line of business. In general, they may be considered as (1) extraction, (2) manufacture, (3) wholesale trading and (4) retail trading. Each type of product passes through the economic process in what is the regular fashion for its line, and spends a certain average length of time in passing through each of the stages.

* Each stage has fairly well defined credit relations with the other stages which are adjacent to it in the process. Most conspicuous, perhaps, is the wholesaler and his relations, on the one hand, with the manufacturer from whom he buys and, on the other, with the retailer to whom he sells. As is generally known, he usually buys for cash and sells on time. These credit relations also imply certain definite relations on his part with the banking system. He must borrow from the banks for a two-fold purpose — in order to pay cash for his purchases, and in order himself to extend credit to his customers. Similarly, every other stage has its own definite relations. At the commencement of the economic process, for example, raw materials are sold for cash by producers, and buyers thus resort directly to the banks for the funds they need. Likewise, at the close of the process, consumption goods are sold at retail in considerable measure for cash, so that the retailer does not have to borrow from the bank to so great an extent in order to extend credit to his customers. In short, every stage has its own definite credit and banking relationships. These relationships are similar in a general way for certain types of business, according to the stage in the economic process in which they belong, and irrespective of the particular goods which each produces or handles. The credit and banking problems of a hardware wholesaler are similar to those of a wholesale grocer — more similar in many ways than are the problems of the wholesale grocer to those of the canner who sells to him.

But at the same time those engaged in any given line of

8 THE MECHANISM OF COMMEKCIAL CREDIT

business are subject to the same influences. The hardware manufacturer, the hardware wholesaler and the hardware retailer are all affected by the ultimate demand for their product. The manufacturer sells to the wholesaler, who in turns sells to the retailer, and there is thus a definite continuity and interdependence between them. Each stage dovetails with and fits into the other. This applies more particularly to the credit than to the banking problems, and the latter feel the influence somewhat indirectly. In any event, however, it is useful to make a two-fold classification according to the kind of credit and banking problem which is experienced — either according to the stage in the economic process, or else according to the line of business.

The apparent complexity of the process in actual life should not be permitted to obscure the simple fundamental features which lie back of it, and have just been explained. Significant for an understanding of the commercial credit system is a two-fold division of the economic process, according to lines of business and according to stages. The credit and banking problems of any individual business man are in considerable measure determined for him, rather than ~by him, according to the line and stage in which he finds himself. Each line and each stage has its definite problems. With respect to any one line of business, the interdependence of the successive stages in that line is perhaps most striking. From the credit point of view, the length of time which the article passing through the process remains in each stage is of special importance inasmuch as it fixes an upper limit to the time for which any one stage should be granted credit. This will be seen more fully in Chapter II. From the banking as well as from the credit 'point of view, the peculiar problems which are found in certain stages, notably the wholesale stage, are perhaps most striking. However, neither division, by stage or by line, can be neglected, and each forms the logical complement of the other.

Relation to Banking. — From the point of view of its relation to banking, the question of the terms employed and hence the structure of the commercial credit system, raises in the first place the question how the paper of the merchant or manufacturer gets into the banks. The primary question is this : whose paper is it — that of the buyer or of the seller, and in what form is it? Where cash is paid, and the buyer discounts his bills instead of paying only at the close of the net period, the buyer goes directly to the bank and borrows from it. Where he instead takes the net terms, the seller must carry him and extend the necessary credit. To do this, however, the seller must go to his bank and either discount the note or acceptance which he may have received from the buyer, or else borrow on his own paper in order to obtain these funds. In the first case the buyer goes directly to the bank, while in the second case the seller goes to the bank and borrows from it the funds which he in effect loans to the buyer when he sells goods to the latter on time. In the first case, the bank has the buyer's paper; in the second case, it has either the seller's paper, or the buyer's paper endorsed by the seller.

In actual practice in the United States to-day, buyers are given the option of paying cash or taking time. Thus they naturally divide themselves into two classes according to whether or not they either possess themselves or can obtain from the bank sufficient funds to enable them to pay the seller cash. The proposals which have been made to reform the present credit system and to introduce widespread use of the trade acceptance in last analysis, however, involve the use of a system of net terms only, under which no option is granted to the buyer, and paper reaches the banks only from the seller. The relative merits of each will be considered fully below. At this point it can merely be indicated that there is involved the further question

"whether better credit measurement is obtained under the one system than under the other.

In the second place, the terms employed raise the question of the length of time for which the bank shall make its advances. The period of credit which it grants parallels the period of mercantile credit, and both are based on the length of time for which the borrower or buyer, as the case may be, requires the funds. This, as indicated above, is determined by the length of time which the article he handles takes to pass through his stage of the economic process. The terms of sale are important from the point of view of the bank in this way as well as in the way just indicated.

Scope and Purpose of the Work. — The framework upon which the present book is built is provided by the commercial credit system described above. This system constitutes our subject of study, and is to be considered from several different points of view. Throughout the system terms of varying descriptions are in use. But throughout the structure of terms which exists, certain forces are at work to determine the terms which shall be used under any given conditions. It is not mere chance that manufacturers sell men's straw hats on a single season dating, while wholesale grocers usually sell their goods on terms of 1 per cent 10 days, net 30 days. Nor is it mere chance that cash discounts as high as 7 per cent are found in various branches of the textile industry, while manufacturers of iron and steel products do not grant discounts in excess of 2 per cent.

The first purpose of the present work is to consider the forces which govern the terms now in use, and which determine what the terms shall be in each line and stage, and in each individual case. These forces are clearly susceptible of analysis, and may readily be discovered. They are concerned in large part with the merchandising and general business practices which prevail. They relate both to the length of the net terms (including the datings granted) and to the size of the cash discounts quoted. In addition to explaining why the regular terms in any given industry are employed, they serve also to explain the deviations from these terms which are found in the case of some individual houses. However, the standard or regular terms which are the result of these forces themselves vary over a series of years in response to changes in general business conditions, and attention will also be paid to the manner in which this variation takes place.

The second purpose is to evaluate critically the present structure of terms in so far as it relates to the present commercial credit system. Various efforts at, and proposals for reformation of the system have been made in recent years, and these strike at the very fundamentals of the system. Is our present cash-discount system good, bad or indifferent? Has it outstanding weaknesses, and if so, how, if at all, may they be remedied? Is it worth while to attempt to remedy them? Do its defects exceed its merits, and, furthermore, is there another and superior system available to supplant it? How does this system compare, point for point, with the cash-discount system? Should the cash-discount system be discarded and the new system — the net-terms or trade-acceptance system — be put in its place ?

Sources of Data as to Terms. — To answer both these sets of queries, requires the use, as far as possible, of an inductive method. This calls, in the first place, for comprehensive data as to the existing terms situation and as to merchandising and business practice in so far as it bears on terms. These have been carefully prepared for leading groups of industries, so as not only to show the existing situation, but also to illustrate the application of the forces which govern terms. They are presented in Part III, Chapters XI to XVI inclusive, of the present work. A comprehensive body of actual fact, therefore, provides the basis for the present study. These data have been carefully analyzed from the points of view indicated in the preceding section.

The data, however, are limited in certain directions. Terms in import and export trade are not included, but domestic trade alone is considered. Neither are terms on agricultural produce and other absolutely raw materials included, and terms in retail trade are also omitted. Where reference is made to these fields, it is necessarily general in character, and the major part of the illustrations are thus drawn from the other fields for which detailed and specific data are available. The general forces which ^re discussed, however, are universal in their application and apply equally to both fields.

Previous Studies. — Little help may be obtained from previous studies of the subject of terms. They are generally both scattered and fragmentary, and fall roughly into two classes: (1) statements of terms in a number of lines, and (2) discussions of the situation in a particular industry. Most of the regular works on credits and collections devote a few pages to the subject, usually, however, only to indicate the nomenclature. At most, a chapter is devoted to a brief discussion of principles and a statement of the situation in a few leading lines, as, for example, in Volume 8 of the Modern Business Series of the Alexander Hamilton Institute. The Credit Monthly, and its predecessor, the Bulletin of the National Association of Credit Men, contain a few brief statements, and so also does Rinsfoos' book on Purchasing. Some material may also be found in various other scattered works, such as the Banking Law Journal Year Book for 1915, on Commercial Paper and Bills of Exchange, and Kniffin, Commercial Paper.

In general, however, these works have the defect of being mere statements of facts with respect to regular terms. Little or no attempt is made to analyze and indicate the factors which determine what terms shall be employed, and in most cases no marketing and other data necessary for an understanding of the terms are appended. Analysis is found to a greater extent in discussions of terms in a given industry. Prominent among this class of works are addresses, reports of committees on terms, and discussions at trade association conventions, as well as discussions at group meetings at the conventions of the National Association of Credit Men. From time to time, articles also appear in trade and less frequently financial journals. The former also contain, at times, statements of the pojicy of individual business houses as to terms. Certain studies dealing with particular industries also consider the problem at greater or lesser length. Among these may be mentioned Onthank, The Tanning Industry and Dodd, Lumbering, both published by the Robert Morris Associates, several studies of the Miscellaneous Series of the Bureau of Foreign and Domestic Commerce, for example, No. 34, relative to men's clothing, several of the studies of the Federal Trade Commission, especially those on agricultural implements, and Cherington, The Wool Industry. In all of these, considerable data as to marketing are included.