Trade Credit Management for Competitive Advantage: a Case of Kenya Insurance Industry

TRADE CREDIT MANAGEMENT FOR COMPETITIVE ADVANTAGE: A CASE OF KENYA INSURANCE INDUSTRY

Table of contents
Signature page............................................................................................................................ii
Declaration ..............................................................................................................................iii
Acknowledgements...................................................................................................................iv
Table of contents........................................................................................................................v
List of tables............ .................................................................................................................ix
List of figures.............................................................................................................................x
ABSTRACT..............................................................................................................................xi
ACRONYMS........................................................................................................................ xiii
CHAPTER ONE 1
Introduction and Background to the Study......................................................................1
Importance of Trade Credit ......................................................................................................... 4
The Nature and Cost of Trade Credit .......................................................................................... 4
Credit Management in Non-Financial Institutions ..................................................................... 5
The Insurance Sector in Kenya ................................................................................................... 6
Statement of the Problem ............................................................................................................ 9
Purpose of the Study ................................................................................................................. 11
Research Objectives .................................................................................................................. 11
Research Questions ................................................................................................................... 12
Study Hypothesis ...................................................................................................................... 12
Rationale of the Study ............................................................................................................... 13
Significance of the Study .......................................................................................................... 14
Assumption of the Study ........................................................................................................... 14
Scope of Study .......................................................................................................................... 15 Limitations and Delimitations of the Study .............................................................................. 15 Operational Definition of Key Terms ....................................................................................... 16
Summary ................................................................................................................................... 16 vi CHAPTER TWO 18
Literature Review 18
Theories of Trade Credit ........................................................................................................... 18
Quality Guarantee Theory ........................................................................................................ 18
Financing Theory of Trade Credit. ........................................................................................... 20
Liquidity Theory ....................................................................................................................... 21
Finance Distress Theory. .......................................................................................................... 22
Transaction Costs Theory. ........................................................................................................ 23
Price Discrimination Theory ..................................................................................................... 24
Trade Credit and Competitive Advantage ................................................................................ 25
Credit Policy ............................................................................................................................. 27
Credit Application and Processing ........................................................................................... 29
Credit Risk Assessment ............................................................................................................ 30
Payment Terms and Conditions ................................................................................................ 30
Debt Recovery .......................................................................................................................... 30
Credit Insurance ........................................................................................................................ 31
Conceptual Framework ............................................................................................................. 31
Empirical Review ..................................................................................................................... 33
Research Gap ............................................................................................................................ 36
CHAPTER THREE 38
Research Methodology 38
Research Design ....................................................................................................................... 38
Population ................................................................................................................................. 39
Sample Size and Sampling Techniques .................................................................................... 40
Types of Data ............................................................................................................................ 43
Data Collecting Tools ............................................................................................................... 44
Data Collection Procedures ...................................................................................................... 45
Questionnaire Pre-test ............................................................................................................... 45
Data Analysis ............................................................................................................................ 46 vii Data Presentation ...................................................................................................................... 49
Ethical Considerations .............................................................................................................. 50
Summary ................................................................................................................................... 50
CHAPTER FOUR 51
Data Analysis and Results 51
Response Rate ........................................................................................................................... 51
Gender Response ...................................................................................................................... 52
Department Response ............................................................................................................... 53
Education Response .................................................................................................................. 54
Age Bracket .............................................................................................................................. 54
Nature of Products .................................................................................................................... 55
Tests for Normality ................................................................................................................... 56
Motives for Advancing Trade Credit ........................................................................................ 57
ACP and Firm size .................................................................................................................... 59
ACP and Competitive Advantage ............................................................................................. 62
Comparison between Current Trade Credit Management Practices in the Insurance Industry with Best Practice ..................................................................................................................... 63
Summary of Key Findings ........................................................................................................ 65
Motives for offering Trade Credit by Insurance Companies. ................................................... 65
ACP and Firm Size ................................................................................................................... 65
ACP and competitiveness of a firm .......................................................................................... 65
Comparison of Current Trade Credit Practices with Best Practice .......................................... 65
Chapter Summary ..................................................................................................................... 66
CHAPTER FIVE 67
Summary Of Findings, Conclusions and Recommendations 67
Summary of findings 67
Motives for supply of trade credit ............................................................................................. 67
ACP and Firm Size ................................................................................................................... 67
ACP and competitiveness of a firm .......................................................................................... 68 viii Comparison of Current Trade Credit Practices with Best Practice .......................................... 68
Conclusions 69
Recommendations 70
Limitations of the study 70
Areas of further research 70
REFERENCES 72
Appendix 1: List of Insurance Companies in Kenya. 81
Appendix 2: Questionaire 83 ix LIST OF TABLES
Table 3. 1:Population and sample size .............................................................................. 43
Table 3. 2:Sample respondents ......................................................................................... 43
Table 4. 1: Skewness/Kurtosis tests for Normality ........................................................... 57
Table 4. 2: Motives for advancing Trade Credit ............................................................... 59
Table 4. 3: Firm size and ACP .......................................................................................... 60
Table 4. 4:Model Summary .............................................................................................. 61
Table 4. 5: Coefficients ..................................................................................................... 62
Table 4. 6: Model Summary ............................................................................................. 63
Table 4. 7: Coefficients ..................................................................................................... 63
Table 4. 8: Current trade credit practice compared to best practice ................................. 64 x LIST OF FIGURES
Figure 2. 1: Relationship between ACP and firm size................................................32
Figure 2. 2: Relationship between PBT and ACP.......................................................32
Figure 4. 1:Response rate............................................................................................52
Figure 4. 2:Gender Response .....................................................................................53
Figure 4. 3: Department Response..............................................................................53
Figure 4. 4: Education Level .....................................................................................54
Figure 4. 5: Age Bracket.............................................................................................55
Figure 4. 6: Nature of Product....................................................................................56 xi ABSTRACT
This study examined the concept of trade credit management and its potency for bringing about competitive advantage in the insurance sector. The study focused on the Kenyan Insurance sector which is comprised of both life and general insurance companies. The purpose of this study was to establish why the insurance companies offer trade credit and whether good trade credit management practices as evidenced by the level of ACP results in higher competitive advantage among insurance firms. The objectives of the study included; (i) To establish the motives for the supply of trade credit by Insurance companies in Kenya (ii) To establish whether the quality of trade credit management practices as measured by ACP differ between firms of different sizes (iii) Establish whether there is a relationship between the quality of trade credit management practice as measured by ACP and competitiveness of a firm and (iv) To compare the credit management practices in the insurance industry with the best practice and draw valid policy recommendations for improvement.
A descriptive survey design was used due to its methodical choice of samples. A population of 44 insurance firms was identified at Appendix 1 and a sample of 24 insurance firms (55%) was appropriate for this study. Random sampling technique was used to select the 24 firms from the population. Stratified sampling technique was used to select 96 respondents from the 24 firms. Specifically, a total of 4 respondents were drawn from 4 departments in each of the 24 firms.
A questionnaire was the preferred data collection instrument and both primary and secondary data were collected. A response rate of 37% was obtained. Inferential statistics such as chi-square statistics were used to test for significance in mean responses while regression statistics were used to establish whether a relationship existed (association) between identified xii variables.
The findings were presented in the form of graphs; charts value tables. Findings from the study implied that insurance companies motives for offering credit are in line with the quality guarantee theory, transactions theory, Finance Distress Theory, Liquidity Theory and Financing Theory of Trade Credit. Findings also implied that ACP differs between large firms and small firms. Moreover, there was a negative relationship between the firm size and ACP as reflected by a coefficient of -0.002. This means that the smaller the size of the firm, the higher the ACP and the larger the firm the lower the ACP.
In addition, there is a relationship between the quality of trade credit management practice as measured by ACP and competitiveness of a firm. Specifically, there was a negative relationship between the ACP and PBT as reflected by a coefficient of -22.2. This means that an increase in ACP by 1% leads to a decrease in PBT by 22%. Finally, study findings indicated that current trade credit practices by insurance companies were not in line with best practice. Therefore, the findings were consistent with study expectation which was that poor credit management practices were in existence. xiii ACRONYMS
AKI- Association of Kenya Insurers
IRA- Insurance Regulatory Authority
TA- Total Assets
ROA- Return on Assets
ACP- Average Collection Period
IFRS- International Financial Reporting Standards
SMES- Small and Medium Enterprises
CCC- Cash Collection Cycle
CHAPTER ONE
Introduction and Background to the Study
Although trade credit has long been an important source of finance for business firms it is one of the least understood methods of doing business. One possible reason for the misconceptions about trade credit is its varied nature. It is not only financial in nature but also reflects production and marketing decisions (Long, Malitz & Ravid, 1993). Numerous theories had been posited in the last three decades in attempt to explain its existence and use.
Credit management has been a neglected function in many organisations with the only focus given to the end activity of debt collection. The front end activities of credit management such as negotiations, risk screening, using credit information and establishing credit policies has been neglected (Peel, Wilson & Howorth, 2000). This had led to failure of more and more businesses even when some were having a positive trend in growth of sales. Lindsay (2008) observed that:
For the past few years the priority in most businesses was to grow sales. Control on cash flow was a low priority. The value of trade credit management was low, a habit rather than a need or a strategy. From the trade credit industry perspective the basics of trade credit and good cash control were ignored and the pain of business failure forgotten. (p. 16)
The rapid growth of many firms makes them consume more cash than they are generating causing them financial distress (Peel et al, 2000). According to Nwankwo and Richardson (1994) poor management of cash flow had been the major cause of business failures. Working capital management especially trade credit has been a major problem for growing companies (Dodge, Fullerton & Robbins, 1994). Poor working capital management in growing firms is further compounded by the problem of credit rationing
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from financial institutions. The inability of financial institutions to fully evaluate the risk for small and medium firms makes them unwilling to release funds to the sector (Cosh & Hughes, 1994).
The rationing of credit by financial institutions forces the small and medium firms to rely heavily on short- term funds such as trade credit for survival. Over reliance on short-term funds means that efficient management of working capital and in particular good credit management practice is critical for their survival (Peel and Wilson, 1996). In the UK for example, it has been observed that delay in payment of commercial debt (trade credit) is the killer of many small and medium firms (Peel and Wilson, 1996).
In the UK, two propositions on how the problem could be solved had been suggested. One proposition was for the government to intervene by way of a legislation that would impose penalty interest for delayed payment of commercial debts. The promoters of this view argued that such a provision would create a level playing field by binding all firms to pay promptly and ease the cash flow problems of small firms, who will be compensated for any overdue payments. A notable proponent of this view was the Forum for Private Business (Peel et al, 2000). The alternate view was that if owners of firms were made more aware and trained on the best credit management practice they could reduce the amount of overdue debt and alleviate the problem. A notable proponent of this view was the Institute of Directors (Peel et al, 2000).
Close home, the situation for the insurance sector in Kenya fits well in to the picture as described by Jon Lindsay. Historically, Kenya had experienced a large number of business failures in this sector and yet the sales volumes for the failed companies had been growing from one year to the next. Again, most of the insurance companies are
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small and medium in size. Insurance firms such us Kenya National, Stallion, United, Lakestar, Liberty, Access, Invesco and Standard all went through a period of financial distress and finally became insolvent. Due to a weak regulatory structure, the industry’s regulator failed to pick the illiquidity signs on time and the firms could not be salvaged. Notably, they all collapsed while still carrying huge amount of receivables (debtors) in their balance sheet. May be had they managed to collect their receivables on time the situation would have been different.
In an attempt to alleviate the problem of poor debt collection the government legislated a statutory provision requiring insurance premium to be settled up-front through Insurance Amendments Acts of 2006 and 2007. The legislation is referred to as “cash and carry” in the insurance industry. However, the cash and carry legislation had achieved little success in reducing the level of receivables carried by insurance companies. In lobbying for the cash and carry provision, the Association of Kenya Insurers (AKI) hoped that this would solve the problem of debt collection in the sector. However, the problem has continued to bite.
This study aimed to find out why, despite the legislation on cash and carry, the Kenya insurance companies continue to offer trade credit, how they manage the credit and establish the factors that determine the trade credit levels. The study also examined the different ways in which trade credit management had been used strategically and pro-actively as a competitive tool to improve companies’ liquidity, efficiency and profitability and to add value to shareholders’ wealth.
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Importance of Trade Credit
The word credit comes from the Latin word ‘credere’ meaning ‘trust’. When a seller transfers his wealth to a buyer with a promise to pay at later date there is a clear implication of trust that the payment will be made on the agreed date (Bass, 2000). Once the good or services are sold on credit, the seller is no longer in possession of them and only one part of the exchange has taken place. The time lag between the exchange of goods or services and the exchange of money may occasion a loss through delayed payment or total default (Salima, 2008b)
“Credit, like the honour of a female, is of too delicate a nature to be treated with laxity- the slightest hint may inflict an injury which no subsequent effort can repair” (The Morning Chronicle (1825), as cited in Bass, 2000, p.3). Before 1920’s, companies did sell mainly for cash but allowed credit to known and trusted customers. Payments delays were frowned upon and rare, while actual bad debts were shocking and a cause of inquests and sackings (Edwards, 2000). However, in present times credit has become the oil of commerce. Vast volumes of goods and services exchanging hands among market players today are only possible on a ‘buy now-pay later’ basis. Nowadays, most customers take credit for granted and achievement of vast volume sales may become difficult if the seller demanded cash up-front (Bass, 2000).
The Nature and Cost of Trade Credit
It is important to note that credit bear a cost. The cost of the seller having to borrow funds until the cash is received from the purchaser. There are other costs associated with granting of trade credit which may includes staff, stationery, equipments, credit information, debt recovery among others (Salima, 2007b). Ideally, these costs
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should be factored in the price charged for the goods or services. However, even where these costs are factored in the price, additional cost may set in when the customer fail to pay on time. This unplanned for cost erodes a seller’s profit margin and may completely wipe it out if the margins were thin (Bass, 2000). The associated cost of credit implies that there is a dire need for sellers to deliberately plan and manage credit. Thus, the whole process of who to give credit? how much? and for how long? has to be managed in all its intricacies.
Credit Management in Non-Financial Institutions
For many non-financial institutions in third world including Kenya the knowledge and skills necessary for effective management of trade credit is generally limited. Many firms have gone into liquidation over the years as a result of running a deficit cash flow from operations (Pike, Cheng & Chadwick, 1996). Only a small fraction of the non-financial institutions employ basic trade credit management practices with the majority of the firms showing a high prevalence of subjective trade credit decision-making (Peel et al, 2000). Evidence from various researchers concur that the rapidly changing business environment is resulting in a higher rate of company insolvency, increased levels of payment delinquencies and from trade insurer’s perspective, increased claims (Salima, 2007a). There is no doubt that the subjective rule of thumb on management of trade credit is not working as anxiety and worry have set in with more and more companies unwilling to extend credit terms to their trading partners for fear of delayed payment(Neil & Baker, 2009).
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The Insurance Sector in Kenya
In developed economies insurance premium is typically collected before commencement of insurance cover and therefore before any loss or claim is paid. Therefore achieving liquidity is not a particular problem for insurance companies in these economies. The main challenge for these companies is in the correct estimation of occurrence of negative events so that they can preserve adequate level of liquid reserves (Borch, 1990).
However, the situation is somewhat different in Kenya. Until the Insurance Amendment Act of 2006 and 2007 came in force, insurance premium was generally received much later after the commencement of the insurance cover. The insurance Act allowed insurance brokers to hold insurance premium collected on behalf of insurance companies for a period of 60 days (The Insurance Act Cap 487) irrespective of whether cover had commenced or not. This delayed the receipt of insurance premium by respective insurance companies. Further, the delay in collection of premium was compounded by a weak regulatory framework (AKI, 2005). Policy holders, insurance agents and brokers flouted the Insurance Act with impunity by failing to remit collected premium within the stipulated period (AKI, 2005). Some would remit the premium late and by instalments whereas others diverted premium to other use. The delay and delinquency in remittance of insurance premium presented the insurance companies with huge volumes of unpaid or uncollected premium (Kumba, 2009). Some of the companies collapsed under the weight of the huge uncollectable debt and escalating claims.
Insurance firms typically make money by investing the difference between the premiums they receive from clients and management expenses and claims paid out when
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risks occur. This is known as ‘float’ in the business. It is from the float that investment portfolios are build and other assets accumulated. According to Holden & Ellis (1993) insurance companies get liquidity from underwriting income (float), investment income and in liquidation of assets. Therefore the delay in receipt of premium had dire liquidity implication for insurance companies in Kenya.
The amendment of Insurance Act in 2006 and 2007 introduced a cash and carry approach to insurance in Kenya. This changed the way insurance business had been carried out in the past. Premium was to be paid up-front before commencement of cover. It was envisioned that the new legislation would solve the problem of brokers withholding premium to the detriment of underwriters. The cash flows and claim servicing by underwriters would improve as companies will be able to invest and generate profits before claims were incurred. The perennial liquidity challenge of underwriters doing public service vehicles (PSV) insurance business would be resolved.
However, the amendments to the Insurance Act did not come without challenges.
Despite the cash and carry legislation being in force the insurance companies continue to carry huge debtors’ balances in their balance sheets (IRA, 2010). After the introduction of cash and carry there was some disquiet in the insurance industry that some customers with large insurance balances had curtailed their insurance needs since they could afford to pay the balances up-front at once (Finance Post, 2009). Companies were allowing customers with large sums to pay by instalments rather than loose them. According to the general manager of CIC Insurance, Mr. K. M. Kimani, some companies were allowing credit to lure customers from more strict underwriters forcing them to respond by devising credit policies of their own to protect their turf (personal communication,
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September 20, 2010). Trade credit has become a strategic competitive tool for many companies in the industry.
Meanwhile, IRA responded to what was happening in the industry by devising a new provision to enforce cash and carry. As an indirect measure of enforcing cash and carry the regulator derecognized debtors as an admissible asset for the purpose of statutory reporting purpose. This meant that although debtors would remain as an asset in the balance sheet of insurance companies as per the requirement of International Financial Reporting Standards (IFRS), it will be written down to zero value for the purpose of statutory reports to IRA. This requirement had a serious consequence on calculation of solvency margins for the insurers. Most companies could not meet the minimum solvency threshold required in order to attain a trade licensing from IRA. By the first quarter of 2010 only 8 out of 43 insurance companies had acquired trading licenses (IRA, 2010).
The threat of loss of trading licenses occasioned by insolvency jolted the management of many companies from their comfort zones. They had to act quickly to rectify the situation. They had either to inject fresh capital or carry out aggressive debt collection. The option to inject capital was out of question for many as they were already struggling to raise capital in order to comply with the Insurance Amendment Act 2006 which had increased minimum capital from Kenya Shillings 100 Million and 50 Million to 300 Million and 150 Million for general insurance and life assurance companies respectively.
The only available option left for many companies was to aggressively collect the outstanding premium. As previously observed by Peel et al. (2000) focus was only given
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to debt collection. The whole process of credit management was ignored. The frantic debt collection effort for most companies succeeded in helping them achieve the minimum solvency threshold required for licensing. However, this success was only short term. By the third quarter of 2010 many companies had fallen back and were carrying huge debtors balances (IRA, 2010). This was indicative of poor credit management practices in the sector.
Statement of the Problem
After every few years an insurance company collapses in Kenya due to insolvency. Ten companies had collapsed within a period of ten years from 2001 to 2010 (IRA, 2009). Whereas various reasons had been posited as the cause of their failures two things stood common for all of them. They were relatively small in terms of market share and they all collapsed when carrying huge amount of debtors (receivables) in their balance sheets (IRA, 2009).
The insurance industry had been struggling with the problem of debt collection for a long time. However, through their umbrella organization AKI, the industry successfully lobbied the government to change Insurance ACT Cap 487 by introducing upfront payment of premium for motor insurance (AKI 2006). The upfront payment was further expanded to cover all classes of insurance through an amendment to the Insurance Act in 2007 (Insurance Amendment Act, 2007). This new development was popularly referred to as the ‘cash and carry’ rule of insurance by the industry. However, even with the advent of the cash and carry legislation in 2007 these companies have continued to offer trade credit ( IRA, 2009). Whereas the relatively large ones have managed to control their receivables the rest are really struggling. This status was echoed by the in the extracted
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speech of Association of Kenya Insurers (AKI) chairman, Mr Nelson Kuria who expressed his concern that:
It is an open secret that underwriters are not complying fully and that credit is still being given albeit at a more controlled level. This situation of limited credit was expected to be there as a transition with our ultimate goal to being fully compliant. What is disconcerting is that a few of us may be relapsing to the old bad manners and indeed there are murmurs about a few brokers who have started to accumulate unpaid premiums and that these few brokers have resorted to threats and intimidation when asked to pay (Kuria, 2009).
The magnitude of the debt problem is further affirmed by IRA report that showed that the industry was owed Kenya Shillings 8 Billions of unremitted premium by 31st December 2009 (IRA, 2009).
As an indirect means of encouraging compliance with cash and carry, IRA had disallowed inclusion of outstanding premium as part of company assets for solvency determination (circular). As a result of this seven companies had not met the minimum solvency margins required for licensing by 31st December 2009 (Makove, 2009). Had these companies managed to collect the outstanding premium the status would have been different. Debt collection and in essence debt management has continued to pose a serious challenge for many firms. Different firms continue to offer credit with mixed results. This calls for an in-depth investigation on the credit management practices adopted in the industry.
Past research work on the management of trade credit as an element of overall working capital in Kenya had focused on reason for existence of and the use of trade credit in the manufacturing sector (Isaksson, 2002; Kitaka, 2000). Furthermore, past studies in Kenya in the area of trade credit management had concentrated on the financing aspect of trade credit. Some have looked at the determinants of access to trade
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credit (Isaksson, 2002) and others on trade finance as an external source of finance for SMEs (Atieno, 2001). While some of the studies had focused on SMEs and a few on the manufacturing sector none had focused on the insurance sector. This sector also known as the “ugly sister” to the banking sector has failed to attract scholars to examine the issue of trade credit management. In fact, majority of studies in the sector are confined to the investigation of insurance claims and performance (Kirema, 2009), However, none of these studies approach the issue of trade credit management with the theoretical rigor that it deserves. The mainstay of this study was a rigorous approach to trade credit management in the insurance sector from both a theoretical and empirical point of view so as to determine its impact on competitive advantage.
Purpose of the Study
The purpose of the study was to establish why the insurance companies offer trade credit and whether good trade credit management practices as evidenced by the level of ACP results in higher competitive advantage among insurance firms.
Research Objectives
The study aimed to fulfil the following objectives:
1) To establish the motives for the supply of trade credit by Insurance companies in Kenya.
2) To establish whether the quality of trade credit management practices as measured by ACP differ between firms of different sizes.
3) Establish whether there is a relationship between the quality of trade credit management practice as measured by ACP and competitiveness of a firm.
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4) To compare the credit management practices in the insurance industry with the best practice and draw valid policy recommendations for improvement
Research Questions
The researcher wished to determine answers to the following research questions:
i) What are the motives for offering and seeking trade credit among insurance companies in Kenya? ii) Do the qualities of trade credit management practice differ between firms of different sizes? iii) Is there a relationship between the quality of trade credit management practice and competitiveness of a firm? iv) What inferences can be drawn from the comparison between trade credit management practices in the insurance industry with the best practice?
Study Hypothesis
The relationship between firm size and Average Collection Period was demonstrated in Zainudin (2008). It was therefore important to test whether there are significant differences in ACP between firms of different sizes. In addition, the study hoped to test the hypothetical causal and association relationships between competitive Advantage (Measured by ROA) and ACP. The following formed the study hypothesis:
H1: The ACP differs between firms of different sizes
H01: The ACP does not differ between firms of different sizes
H2: There is a positive relationship between ROA and ACP
H02: There is no positive relationship between ROA and ACP
H3: Proper trade credit management (lower ACP) impacts positively on Competitive Advantage (PBT)
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H03: Proper trade credit management (lower ACP) does not impact positively on Competitive Advantage (PBT).
Rationale of the Study
Trade credit is like a double edged sword. It can confer benefits if well managed but can be detrimental if poorly managed. If well managed trade credit can confer competitive advantage. It can not only be a source of finance when other sources of funds are not available or are more expensive but can also promote sales by allowing flexibility in payments and can also help in attracting and retaining customers among other benefits. Trade credit, on the other hand, can be detrimental if not well managed because it comes with some associated costs.
The Insurance industry has been a great supplier of trade credit as evidenced by the level of trade receivables in their balance sheets. However, the perennial problem of debt collection in the industry is a pointer to an underlying problem on the way trade credit had been managed in the past. The industry players needs to understand the whole process of credit management; who to give credit? how much? and for how long? The whole process has to be managed in all its intricacies if companies are to derive competitive advantage from trade credit.
From the study some recommendations on how trade credit management can be used strategically and pro-actively as competitive tool to improve companies’ liquidity/solvency, efficiency and profitability and to add value to shareholders wealth were suggested.
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Significance of the Study
1. Firms in the insurance sector will find this study useful as it will indicate the implications of good trade credit management as a tool in enhancing solvency and profitability. The findings of this study may therefore be used as a blue print for improving on trade credit management practices not only for the insurance sector but also for small and medium enterprises in the private sector.
2. The Insurance Regulatory Authority (IRA) may find this study useful as it will highlight the current state of trade credit management in the insurance sector. The study findings will help to pinpoint weakness and policy gaps that need a remedy. Consequently, IRA may use the study findings to inform policy interventions in the insurance sector.
3. The findings of this study will be an important addition to pedagogic literature and scholars wishing to further their knowledge on the discourse of trade credit management. Therefore, students of Economics, Finance, Business, Management and Insurance will find this study useful.
Assumption of the Study
In undertaking this study, the researcher made the following assumptions:
(i) The firms under study were willing to provide true information about trade credit practices and profitability levels.
(ii) The choices of respondents (managers) were knowledgeable enough of the trade credit management practices.
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(iii) That change in the levels of overdue accounts during the study period was wholly attributable to the implementation of the trade credit management practices.
(iv) That the firms under study were representative of other small and large enterprises in the insurance sector for the easy adaptability of the findings.
Scope of Study
The study was on the trade credit management and its impact on the profitability of the insurance sector in Kenya. The study was conducted in Kenya and involved data collection from the 44 insurance firms which offer both life and general insurance products. The information collected related to the year 2009. Limitations and Delimitations of the Study 1. The required data was quite sensitive, hence it was difficult to obtain. To overcome this limitation, the researcher assured the firms of confidentiality and that none of the information would be disclosed without prior consent from the insurance firm’s management. The researcher sought information from secondary sources such as the Insurance Regulatory Authority where it became difficult to obtain directly. 2. Some respondents lacked time to answer to the questionnaires due to the hectic nature of their jobs. To overcome this limitation, care was taken to replace the non-cooperative respondents with cooperative ones from the same target group.
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Operational Definition of Key Terms
Trade credit management
Trade credit management can be viewed as a contractual solution to information problems between sellers and buyers ( Pike, Cheng & Lamminmaki, 2005).
Insurance company
These are firms that help to mitigate against the effects of risk by offering compensation in the event of loss in exchange for a charge known as premium.
Working capital management
According to Weston and Copeland (1986) working capital is defined as current assets minus current liabilities. Further, according to Enhardt and Brigham (2009), working capital represent the firm’s investment in cash, marketable securities, accounts receivable, and inventories less current liabilities used to finance the current assets.
Profitability
According to Pandey (2006), profitability is commonly referred to as the net income arrived after subtracting expenses from the gross income.
Account receivables
According to Pandey (2006) accounts receivables are debtors arising from credit sales made to firm’s customers.
Account payables
According to Pandey (2006), account payables are the creditors arising from credit purchases from suppliers.
Summary
The chapter dealt with the relevant background of trade credit management and the credit challenge of the insurance sector and the regulatory effort to alleviate the problem. The objectives, the research questions, the justification and the scope of the study were also set out in this chapter. The rest of this study was organized as follows;
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Chapter 2 examined different theories of credit supply and demand and compared these with the current practice in the insurance sector. Chapter 3 discussed the research design and methodological frameworks employed to accomplish the stated aim and objectives of the study. Chapter 4 presented the analysis, interpretation and descriptions of the results relating to the insurance sector with reference to the aims and focus of the study. And chapter 5 drew conclusion from the study and formulated policy recommendations as well as areas of further research.
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CHAPTER TWO
Literature Review
This chapter discusses the trade credit theories that had been posited in an attempt to explain the reason for the demand for and supply of trade credit by customers and suppliers respectively. In addition the chapter discussed the best practice in trade credit management and reviewed the existing literature that support or argue against the use of trade credit management in attainment of competitive advantage. It is from the empirical discourse that the knowledge gap was established.
Theories of Trade Credit
This section discussed several well-developed theories explaining why trade credit is used in developed countries. The foundation of these theories is the high level of trust among suppliers and customers and also a well functioning enforcement mechanism. However, in developing economies the social-economic conditions are quite different from those in developed countries which imply some peculiarities for these economies. However, although not fully applicable, existing trade credit theories designed to explain the developed countries experience, may still shed some light on the use of trade credit in developing economies.
Quality Guarantee Theory
According to this theory, trade credit is used to overcome the problem of information asymmetry between the sellers and buyers of goods and services. When buyers are faced with uncertainty as to the quality of a supplier’s product they would demand sufficient time to test, assess and confirm the quality Pike, Cheng, Cravens and Lamminmaki, 2005).The credit period affords them an opportunity to asses value for
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money before payment. Therefore, when faced with uncertainty in regard to product or services quality, buyers with alternatives will always go for suppliers who offer trade credit (Lee and Stowe, 1993). From the perspective of uncertain buyers, trade credit is an implicit guarantee by the seller of the product quality (Deloof and Jegers, 1999). It is believed that sellers who are uncertain of their products/services would not offer credit for fear that any defects or flaws in the product will be discovered within the credit period and jeopardise payment.
Suppliers extend trade credit because they have an immense interest in a customer’s success, since they expect the client to buy more goods and service from them in the future. On the other hand they are faced with uncertainty that when an order is placed the customer does not intend to pay on time (delinquency risk) or the customer does not intend to pay at all (Default risk). Sellers will use trade credit to gather information about the credit worthiness and financial health of their customers. Sellers would try to minimize the risk payment default through initial credit screening and setting of credit terms (Pike & Cheng, 2001). Credit granted may incorporate an element that encourages early payment. For, example 2/10 net 30 days ; which allows a rebate of 2% if the buyers pays within 10 days else full amount will be expected in 30 days. Sellers will gather valuable information about customers ' financial health through their payment patterns and their abilities to take advantage of discounts for early payment when offered (Petersen & Rajan, 1995). Inability to take trade discount may provide a powerful signal that the customer is experiencing financial difficult and there is a high risk of default. Sellers also use trade credit to communicate quality consistency of their products and long-term commitment to serve customers (Salima & Bodden, 2008)
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Financing Theory of Trade Credit.
The finance theory of trade credit suggest that imperfections in the credit markets causes the financial institutions to ration credit finance to some business, forcing them to seek alternative sources of finance, that is, from suppliers( Wilson, Singleton & Summers, 1999) . This rationing comes about because of the information asymmetry between lenders and borrowers. Lenders have insufficient information to assess the risks of lending to certain business borrowers and are unable or unwilling to incur the costs involved in setting an appropriate interest premium for all classes of customer risk (Salima, 2008b).The credit rationed borrowers are forced to seek trade credit as a means of short-term financing of their working capital requirements. Therefore, trade credit provides access to capital for firms that are unable to raise it through the traditional channels .Trade credit can therefore be viewed as a substitute for institutional financing (Pike, Cheng, Cravens & Lamminmaki, 2005) . Trade can also be viewed as complimentary to bank credit (Burkhart, 2004).
According to the financing theory, suppliers of trade credit act as intermediaries between the financial institutions and the credit rationed firms. Credible firms obtain cheap institutional finance and transmit the funds to those whose perceived risks are not of acceptable standards according to the financial institutions (Bhattacharya, 2008). The suppliers are able to assume this risk because they enjoy several advantages over the financing institutions. One such advantage is that the supplier interacts with the borrower on day to day basis. This interaction affords the supplier an opportunity to gather up to date information of the borrower which is used for sound credit evaluation. Furthermore, the day- to-day interaction accords the supplier an opportunity to closely monitor the
21
borrower at minimum costs (Biais, Gollier, 1993). Such an opportunity is not available to financing institutions and close monitoring of borrowers can only be done at great costs.
The second advantage is that the supplier is in a better position to salvage value from the borrower’s assets. If the borrower’s default in payment the supplier can seize the goods that have been supplied and dispose them through the normal business channels. However, this will depend on the type of goods supplied and how much the customer transforms them. Durable goods that require no or little transformation will provide better collateral since they can be disposed through the normal business with little additional costs. This advantage is not available to financing institutions that are forced to incur additional costs of ascertaining the value of the seized goods and searching for a buyer (Mian & Smith, 1992).
The third advantage is the supplier’s ability to control the borrower. The supplier can always threaten to stop additional suppliers if the borrower defaults in payment. This is a very effective mechanism where the borrower enjoys limited alternative sources of supply. “By contrast, a financial institution may have more limited powers; the threat to withdraw future finance may have little immediate effect on the borrower’s operations” (Bhattacharya, 2008).
Liquidity Theory
This theory is an extension of the financial theory. It posits that credit rationed firms and those with negative cash flows use more trade credit than those firms with access to traditional sources of finance (Petersen & Rajan, 1997). The central point of this theory is that trade credit can be used to bridge the gap between demand for credit and the supply availed from financial institutions (Baston & Pindado, 2005). According to
22
Petersen and Rajan (1997) firms with good liquidity or with easy access to capital markets can act as financial intermediaries between the credit rationed firms and the financial institutions by funding the credit rationed firms through trade credit. During the time of monetary contraction, credit rationed firms react by borrowing more from their suppliers (Nielson, 1999).
Finance Distress Theory.
According to this theory financially distressed firms use more trade credit from suppliers than wealthy ones and that finance distress may breed “opportunism” (Bhattacharya, 2008). Burkart (2004) suggests that suppliers increase trade credit financing to their clients because the goods they sell them constitute better collateral for their credit since they are less deployable than cash. Evans (1998) posits that suppliers desirous of maintaining a long-term product market relationship grant more concessions to a customer in financial distress, as compared to similarly positioned lending institutions. Wilner (2000) also posit that where the degree of dependence of a supplier on a customer is high the customer in financial distress obtains larger concessions in renegotiation of credit terms.
“Buyer opportunism” may set in when a supplier is in financial distress. A supplier is in a financial distress cannot credibly threaten to stop supplies (Petersen & Rajan, 1997). When the buyers become aware of the predicament of such a supplier they exploit the situation by not only delaying the payments but also pressing for extra concessions such as increased discounts (Bhattacharya, 2008). The buyer’s opportunistic behaviour is more pronounced where the customer is one of the principle buyers. A seller’s opportunistic behaviours may also set in when sellers ‘aid’ financially distressed
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firms by extending generous credit terms to lure them to their fold and subsequently earn larger profits by charging higher rates (Petersen & Rajan, 1997).
Transaction Costs Theory.
This theory holds that when transactions between sellers and buyers are frequent both parties may reduce transaction costs by agreeing to a periodical payment schedule. Rather than paying bills every time goods are delivered, a buyer might want to cumulate obligations and pay them only monthly or quarterly which reduces the frequency of transactions and the associated costs (Bhattacharya, 2008). However, seller are to be careful as saving will only be achieved so long as saving in transaction costs remains more than the cost of holding receivables. Centralization of supply of goods and credit management can reduce overall transaction costs by increasing efficiency in monitoring of both supplies and the credit (Petersen & Rajan, 1997).
Trade credit can also reduce transaction costs associated with variability in consumption patterns as result of seasonality in demand. In order to maintain a smooth production cycles firms may be required to maintain large inventories which may increase the costs of warehousing and financing it. Firms whose product suffers from high demand fluctuations may resort to trade credit, which is found to be the least cost solution, the others being adjustment of production schedule or effecting price reduction (Bhattacharya, 2008). The seller could use trade credit as an operational tool by tightening credit terms when demand increases and relaxing the credit terms when demand slacken (Emery, 1987).
By offering trade credit knowledge of customer behavior gained from experience leads to better forecasts that will reduce the need to carry large amounts of cash, and
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subsequently decrease the cost of holding precautionary cash balances (Pike & Cheng, 1996). Furthermore, customer credit information may be collected in the normal course of business at minimum costs.
Price Discrimination Theory
Even when no advantage exists over financial institutions, trade credit may be used to discriminate between customers (Mian and Smith, 1992). The first form of price discrimination occurs where standard credit terms offered are invariant to the credit quality of the buyer, effectively reducing the cost of credit to lower-risk borrowers. A second form of discrimination occurs where the supplier seeks to deepen the long-term relationship or protect the value of its investment in the customers by offering more generous credit terms.
This leads us to argue that terms may be improved to attract desirable custom, particularly when asset specificity, in terms of effort exerted in seeking to retain customers, is high (Petersen and Rajan, 1997). Furthermore, price discrimination can be manifest as a prompt payment cash discount or ‘unearned discounts’ for settlements within the normal net terms period. Ng, Smith and Smith (1999) found that the majority of suppliers surveyed allowed customers, especially longstanding ones, to take unearned discounts.
Further, we would expect that smaller firms, especially those selling products little different from their competitors, are more likely to offer prompt payment cash discount to customers as an implicit price discrimination or reduction in order to compete with the larger firms.
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Trade Credit and Competitive Advantage
Having understood the theories of trade credit the paper now looks at empirical literature that look at the effect of trade credit management on a firm’s performance.. Specifically, the section wishes to discuss prior literature on whether advancing trade credit can offer competitive advantage to a firm. In this study, the definition of competitive advantage was adopted from Porter (1985). Porter (1985) defines competitive advantage as any activity that creates superior value above its rivals. The explicit assertion by Porter (1985) was that competitive advantage comes from the value that firms create for their customers that exceeds the cost of producing that value. The key concern for a business is to capture that value which is greater than its cost.
The most explicit attempt to define competitive advantage and sustainable competitive advantage has come from Barney (1991). He states, "a firm is said to have a competitive advantage when it is implementing a value-creating strategy not simultaneously being implemented by any current or potential competitors. A firm is said to have a sustained competitive advantage when it is implementing a value-creating strategy not simultaneously being implemented by any current or potential competitors and when these other firms are unable to duplicate the benefits of this strategy" (p. 102). He additionally asserts that "a competitive advantage is sustained only if it continues to exist after efforts to duplicate that advantage have ceased" (p. 102).
In the empirical work conducted by Molina, Pino and Rodriguez (2004) the the following variables had been used to determine firms ' level of competitiveness: 1. Market share. 2. Profits. 3. Returns. 4. Technological provision. 5. Financial management. 6. Quality of products-services. 7. After sales services. 8. Managers ' educational
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background. 9. Customer loyalty. 10. Supplier loyalty. 11. Location of establishment. 12. Employees ' commitment and loyalty. 13. Employees ' professional know-how. 14. Firm 's reputation.
Cited in Tuan and Yoshi (2010), Newbert (2007) assert that competitive advantage and performance are terms that have been interchangeably used as they are based on the definition of Porter (1985), which asserts that competitive advantage and performance are more or less the same thing. In addition, Powell (2001) indicates a unidirectional correlation: that competitive advantage leads to improved performance, not the opposite, and hence, Powell (2001) argues that tests of direct relationship between competitive strategies or organizational capabilities with performance that do not separately factor in competitive advantage are prone to methodological mistakes. Therefore, studies such as Powel (2001) assert that among the possible relationships between organisational capabilities, competitive advantage and performance, a direct relationship between organisational capabilities and competitive advantage likely exists rather than a relationship straight from that to performance.
Porter (1980) identifies three generic strategies for gaining competitive advantage. These generic strategies are cost leadership, differentiation and focus. Scholars who argue that trade credit offer competitive advantage allude to the price discrimination theory, the quality guarantee theory and the transactional cost theory of trade credit.
It can be seen from above that the transactional cost theory of trade credit aims at creating competitive advantage through the generic strategy of costs leadership. Firms using the price discrimination theory on the other hand can be seen to be using focus as the generic strategy in order to retain such customers or preserve the long term
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relationship with those customers. Firms alluding to the quality guarantee theory in advancing trade credit can be seen to offer a differentiated product in terms of quality, real or perceived. These firms are therefore in a position to charge hire prices for their services of products. This observation is consistent with the general view that the goods bought on credit bear a higher price than goods bought on cash.
Best Practice in Trade Credit Management.
The previous section looked at the trade credit and competitive advantage. In this section the paper looks at the ‘best practice’ in trade credit management.
Best practice is performing all components of the credit management process well. According to the Institute of Credit Management (ICM), (2011) the best practice in trade credit management involves efficient performance of the following tasks; formulating and documenting a credit policy to guide the credit function, finding out about customers by having them complete credit application forms, assessing customers for credit risks, making sure that the credit terms provided to the customers are seen to be a clear part of the contract (not just the small print), following up on payments and recovering of delinquent accounts and hedging against the loss from unpaid accounts through credit insurance.
Credit Policy
A credit policy is a firms preferred way of dealing with trade credit. It is a guideline that spell out how to decide which customers are sold on open account, the exact payment terms, the limits set on outstanding balances and how to deal with delinquent accounts ( Entrepreneur). It acts as a guide to the day-to-day micromanagement of individual buyers accounts.
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To deal with the problem of late payment, the starting point is for business managers to come to appreciate the importance of establishing clear credit policies that are communicated both internally and externally to everyone directly or indirectly involved in the credit function. Internal communication ensures that all staffs know the company’s position on credit. External communication should ensure that external customers are informed in writing about the terms and conditions before sales. According to Salima, (2007a) “This process may eliminate any scope of misunderstanding, ambiguity and any other avenues that might lead to misinterpretation and may have an effect on long-term customer relationship issues”. (p. 22). Once the credit policies are established and clearly stated credit management will have to ensure that the credit terms are enforced
It is a best practice to have a written credit policy for at least four reasons: First, the responsibility of managing receivables is a serious undertaking. It involves limiting bad debts and improving cash flow. With outstanding receivables often being a firm 's major asset, it is obvious that a reasoned and structured approach to credit management is necessary (Salima, 2007a). Second, a policy assures a degree of consistency among departments. By writing down what is expected, different arms of a company (whether marketing, production, or finance) will realize that they have a common set of goals. Conversely, a written policy can delineate each department 's functions so that duplication of effort and needless friction are avoided (Lingard, 2008). Third, it provides for a consistent approach among customers. Decision making becomes a logical function based on pre-determined parameters. This simplifies the decision process and yields a
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sense of fairness that will only improve customer relations (Salima, 2007a). Finally, it can provide some recognition of the credit department as a separate entity, one which is worthy of providing input into the overall strategy of the firm. This allows the department to be an important resource to upper management (Lingard, 2008).
Credit Application and Processing
It is best practice to have customers in need of credit to complete a credit application form. A signed credit application should be considered as the cornerstone of a credit relationship as it not only provides customer information for credit evaluation purpose but also the basis of a formal contract. A good credit application should constitute of an information disclosure clause, validity of information, contractual debt recognizance and legal implications (Bass, 2000). The application can also request financial statements. Financial statements can contain inaccuracies or questionable information but it also helps in corroborating information provided by the applicant on the credit application.
A Credit Application serves the following purposes: it is an information gathering tool, it is an assessment tool to determine amount and duration of credit, it is a cash collection tool, it is a legal document that binds the applicant to terms and conditions of sale, it is an enforcement tool, it is a monitoring tool, it is a marketing tool that markets the credit loan and in essence a 'loan application '. The quality of the credit decisions is in direct correlation to the quality, accuracy, age and dependability of the sources of credit information (Neil & Baker, 2009). A successful Credit Application treatment process should be tooled for speed and efficiency to enhance order flow.
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Credit Risk Assessment
Another element of the best practice in trade credit management is the evaluation of customers for credit worthiness. Before supplying customers with goods and services, a check of their credit risk is important. This can be done by analyzing information from credit reference agencies, company’s financial statements or requesting bank references. Based on the information that is obtained one can then set the credit terms to cover the risk level or even demand cash up-front. Credit scoring may be used to categorize the customer risk levels and hence the credit limits. Credit evaluation is a necessary tool for reducing the risk of bad debts (ICM, 2011)
Payment Terms and Conditions
Before customers are supplied, it is best practice to explain the terms and conditions to customers at the start of the relationship. It is best practice to send out a written confirmation of their order with a copy of the terms and conditions of sale. This enables them to examine the terms and conditions and discuss any problems they have before supply of goods or services is done. It also sets out mutual expectations, which can avoid misunderstandings later (Salima, 2008a). Terms and condition can also be printed on the back of the invoices. It is also important to set out the mode of payment methods that are acceptable. For example, whether by cheques, Electronic Fund Transfers, Letters of credit excetra.
Debt Recovery
Irrespective of the precaution taken, there is always an inherent risk that some customers will not pay on time or will not pay at all. For best practice it is important to identify appropriate recovery procedures in advance. When initial follow up approaches
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fail to elicit an adequate response appropriate recovery process should be started in accordance with organizational procedures and legal requirements (Lindsay, 2008). Recovery process should be monitored closely for progress and support
Credit Insurance
It is best practice in trade credit management to hedge against loss through unpaid sales by taking an insurance cover against specific risky account receivables or on the entire turnover. Simply put, credit insurance is the insurance of trade debtors. An insurance policy issued, covering the domestic or international debtors (UK Credit Insurance Specialist). By paying a nominal fee in form of insurance premium the risks of bad debt can be eliminated. An insured seller will be secure in the knowledge that he/she will always be paid in case the customer defaulted in payment. Essentially, credit insurance will cover a business ' entire turnover - wherever it may be trading - and will include political risks (Euler Hermes, 2011). However, credit insurance can also cover a business ' key accounts or exceptional losses. As long as the seller operates within the terms, parameters and conditions of the insurance policy, his/her cash flow will be protected by cash replacement if any customer insolvency or payment default occur. Credit insurance affords sellers confidence to explore business opportunities that they would normally avoid for fear of non-payment and thus offers an expanded opportunity for growth. (African Trade Insurance Agency, 2001)
Conceptual Framework
The relationship between firm size and Average Collection Period was demonstrated in Zainudin (2008). It is therefore important to test whether there are significant differences in ACP between firms of different sizes. In addition, the study hopes to test
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the hypothetical causal and association relationships between competitive Advantage (Measured by PBT) and ACP. The following formed the study hypothesis:
H1: The ACP differs between firms of different sizes
H2: Large insurance firms have a lower ACP and small insurance firms have a large ACP
H3: There is a positive relationship between PBT and ACP
H4: Proper trade credit management (lower ACP) impacts positively on Competitive Advantage
Figure 2. 1: Relationship between ACP and firm size
Source: Researcher (2011)
Independent Variables Dependent Variable
Figure 2. 2: Relationship between PBT and ACP
Source: Researcher (2011)
Firm Size (Total Assets)
Other Factors (Dummy)
Average Collection Period
ACP
Other Factors
Competitive Advantage (PBT)
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Empirical Review
Pike and Cheng (2001) carried out a study on the trade credit, late payment and asymmetric information. In their study, they drew on theories of trade credit in an effort to explain the level of account receivables in company balances sheets and the determinants of late payment. The study which was a postal survey drew on responses of 700 accountants and finance managers in the united states, United Kingdom and Australia and it was supplemented by follow up interviews on selected samples. A total of 718 useable responses out of 1,809 US, UK and AU sampled firms were received, giving an overall effective response rate of 39%.
After comparison of means for the three country samples, Pike and Cheng (2001) identified significant differences for most practices and policies. The results confirm that trade credit is an important business activity for most firms survey. Credit sales account for over 90 per cent of turnover in more than 80 per cent of the US and UK firms surveyed, although the proportion is much lower (61%) in AU.
US firms are generally greater users of credit management tools, having the highest means for risk screening, risk management, financing, collection management, incentives and performance measurement. They also more readily enter into external market arrangements for aspects of credit management, such as use of credit agency reports, invoice discounting and debt collection agents. The study also found out that the choice of prime objective of credit management had a significant impact on the choice of credit policies and practices. Risk Minimization was the prime choice for the objective of trade credit function, followed by profit and sales maximization.
Zainudin (2008) carried out a study on tracking the credit collection period of SMEs in Malaysia. The study explored the average collection period profile of 279 small and medium-sized manufacturing companies in Malaysia using the companies’ financial
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statements from 1999 through 2002. The paper also examined if different industry sectors had different collection periods. The study then related the average collection period to company financial performance as measured by operating profit on total assets. Finally, the study investigated if there was any relationship between collection period and company size. To address these objectives, descriptive statistics were used in providing the profile of the ACP of the Malaysian manufacturing SMEs. Next, to examine whether or not different industry sectors had different levels of ACP, the non-parametric Kruskal-Wallis test statistic was used. Finally, to address the third and fourth objective i.e., to establish the relationships between ACP and financial performance, and between ACP and company size, Spearman rank correlation was used.
From the descriptive summary of the variables, it is found that the mean and the median values (number of days) are very different for most industry sectors. Findings also indicated that the parametric Kruskal-Wallis test statistic was significant signifying that different industries had different levels of ACP. The results of the non parametric spearman correlation test indicated that that there was a weak negative association between collection period and financial performance of SMEs. This means that companies with shorter collection period tend to perform better. The Spearman correlation coefficient of results also revealed that there was also a low degree of negative correlation between collection period and company size for the Malaysian manufacturing SMEs. This negative association implies that smaller firms be likely to experience longer collection period.
Rocangli and Bathala (2007) carried out a study on the determinants of the use of trade credit discounts by small firms. Specifically, the authors investigated the usage of
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Trade Credit Discounts by small firms, and examined the determinants of the buyer’s decision to accept or reject discounts that have been offered by the seller as part of their trade credit terms. The study drew upon two theories to illuminate the firm’s motivation for taking or rejecting trade credit discounts, the Pecking Order Theory of capital structure defined by Myers and Majluf (1984), and the theory of Manager Shareholder Agency conflict first described by Jensen and Meckling (1976).
The model chosen to test the hypotheses was shown below. The authors proposed that the percentage of discounts taken for a firm is a function of variables that proxy for agency costs and monitoring, variables that proxy for sources of financing that affect the firm’s capital structure, variables reflecting financial distress (lack of availability of capital), and firm characteristic control variables.
PCTDISCOUNTS = f(Firm Characteristics, Monitoring and Agency, Liquidity,
Financial Distress)
Findings in Rocangli and Bathala (2007) indicate that the use of trade credit discounts by small firms supports a Pecking Order theory interpretation of their capital structure. More profitable firms, firms that have better availability of internally generated working capital and firms that have access to external sources of credit that are less expensive than trade credit take more trade credit discounts. Furthermore, variables that represent financial distress are strong predictors of a firm’s use of trade credit discounts. The authors observed some evidence indicating that failure to take trade credit discounts represents an agency cost to the firm.
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Lamminmaki and Leitch (2009) in their study on refining measures to improve performance measurement of the account receivable collection function demonstrated that the Average collection period and the aging schedule were deficient in gauging the accounts receivables management function. Rather, the authors advocated for a refinement to accounts receivable metrics based on relating accounts receivable values to their original credit sales, thereby ensuring a direct measurement of collection efficiency.
Wilson (1996) examined the credit management practices adopted by SMEs in UK and found a strong connection between good credit management practices and company performance. For instance, Wilson (1996) , found a strong relationship between efficient cash cycle management and profitability.
Deloof (2003) investigates the relation between working capital management and corporate profitability and suggests corporate profitability can be increased by reducing the debtors days and inventory days. Several other research which look at the relationship between operating performance and cash conversion cycle (CCC) offer similar results of negative association (Shin & Soenen, 1998). In view of the fact that CCC depends on the inventory, receivables, and payables periods, cutting down the collection period will almost always reduces the CCC. Although these studies employ CCC, rather than the collection period data directly, they implicitly indicated the relationship between ACP and financial performance.
Research Gap
The studies that have been reviewed above were done abroad, that is either the UK, US, Australia or Malaysia. Consequently, their applicability to Africa and to Kenya in particular may be limited to the extent that the socio-economic conditions differ. In
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Kenya past studies in the area of trade credit management had concentrated on the financing aspect of trade credit. Some have looked at the determinants of access to trade credit (Isaksson, 2002) and others on trade finance as an external source of finance for SMEs (Atieno, 2001).
While some of the studies had focused on SMEs and a few on the manufacturing sector none had focused on the insurance sector. This sector also known as the “ugly sister” to the banking sector has failed to attract scholars to examine the issue of trade credit management. In fact, majority of studies in the sector are confined to the investigation of insurance claims and performance (Kirema, 2009). However, none of these studies approach the issue of trade credit management with the theoretical rigor that it deserves. The mainstay of this study was a rigorous approach to trade credit management in the insurance sector from both a theoretical and empirical point of view.
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CHAPTER THREE
Research Methodology
The chapter discusses the research design, the population, the sampling techniques that were used in the study, the data collection instruments, and the data collection methods and procedures. Data analysis and presentation methods are also discussed.
Research Design
According to Cooper and Schindler (2007), Research design is the plan and structure of investigation so conceived as to obtain answers to research questions. The plan is the overall scheme or program of the research. It includes an outline of what the researcher did from writing hypothesis and their operational implications to the final analysis of data. Therefore research design expresses both the structure of the research problem- the frame work, organization, or the configuration of the relationships among the variables of a study- and the plan of investigation used to obtain empirical evidence on those relationships (Cooper & Schindler, 2007).
According to Mugenda and Mugenda (2003), descriptive research is a process of collecting data in order to test hypothesis or to answer questions concerning the current status of the subjects in the study. Further, Observational Research, the researcher observes the current status of a phenomenon and does not involve asking and therefore is more objective as researcher does not rely on self report as the basic source of data. However this method does not focus on a specific set of behaviours.
Exploratory research studies, also termed as formulative research studies, aim at formulating a problem for more precise investigation or of developing the working
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hypothesis from an operational point of view. Such studies usually deal with the discovery of ideas and insights (Kothari, 2004).
An Experimental Research Design involves manipulation of independent variables to determine their effect on a dependent variable. In this case the independent variables are the treatments (Mugenda & Mugenda, 2003). It is usually done in laboratories and not relevant to social studies.
A Descriptive Survey Research Design was used to assess the trade credit management practices in the insurance sector in Kenya and whether they confer any competitive advantage to the firms under study. The design was chosen because of its methodical approach to the choice of samples. In addition, the descriptive approach enabled the researcher to report things the way they are (report of status quo).
Population
In a research study, population refers to those who can provide the required information (Peil, 1995). A population therefore entails all the cases or individuals that fit specifically for being sources of the data required addressing the research problem.
Population refers to an entire group of individuals, events or objects having a common observable characteristic. The target population is defined as that population to which a researcher wants to generalize the results of the study. Researchers draw samples from an accessible population, which represents a manageable population. However this creates a high likelihood of losing the generalizability of the results (population validity) Generalization of research findings largely depends on the degree to which the sample, accessible population, and the target population are similar on salient characteristics (Mugenda & Mugenda, 2003).
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The study targeted a population of all the Insurance firms in Kenya. According to the Association of Kenya Insurers (AKI), there were 44 insurance companies in Kenya in the year 2009. The 44 insurance firms formed the study population and are given at the appendix 1. In this study, the target population and the population were the same since all insurance firms were accessible.
Sample Size and Sampling Techniques
A sample is usually selected from the target and accessible population. The sample must be large enough to represent the salient characteristics of the accessible population and hence the target population. The sample size depends on factors such as the number of variables in the study, the type of research design, the method of data analysis and the size of the accessible population. For descriptive statistics, ten per cent of the accessible population is enough (Mugenda & Mugenda, 2003).
Sampling is the process of selecting items, persons, objects from a target population that would represent that population in a research (Mugenda & Mugenda, 2003). Probability sampling aims at selecting a reasonable number of subjects, objects or cases that represent the target population. Random sampling allows us generalizability to a larger population with a margin error that is statistically determinable. It also allows the use of inferential statistics, statistical indices calculated on the sample can be evaluated to determine the degree to which they accurately represent the population parameters. Non- probability sampling is used when a researcher is not interested in selecting a sample that is representative of the population (Mugenda & Mugenda, 2003).
In order to have confidence that the survey results are representative, it is critically important that the study has a large number of randomly-selected participants in
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each group you survey. Niles (2006) posits that a 95% confidence level means that there is only a 5% chance of your sample results differing from the true population average and that a good estimate of the margin of error (or confidence interval) is given by 1/√N, where N is the number of participants or sample size.
Morris (2004) opined that when sampling from a small population (less than 200 members) a far smaller sample than that calculated using the normal approximation to the binomial a population is required. “To determine the sample size for small populations, we use the normal approximation to the hypergeometric” (Morris, 2004, p.1) .The formula applicable is as follows: n = NZ² pq
(E²(N-1) + Z²pq)
Where
n is the required sample size
N is the population size p and q are the population proportions.
Z is the value that specifies the level of confidence you want in your confidence interval when you analyze your data. Typical levels of confidence for surveys are 95%, in which case z is set to 1.96.
E sets the accuracy of your sample proportions.
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Niles (2006) had developed a guide table for selection of sample sizes aimed at achieving different levels of confidence:
Accuracy (+/-) (Margin of error)
Confidence Level
90% 95% 99%
Sample size
Sample size
Sample size
1
6765
9604
16576
2
1691
2401
4144
3
752
1067
1848
4
413
600
1036
5
271
384
663
10
68
96
166
20
17
24
41
Source: Niles (2006)
For the purpose of this study, given a confidence level of 95% and a margin of error of 20%, a sample size of 24 firms was selected using the random sampling approach.
Purposive sampling was applied to select the departments that are directly involved with trade credit. Four questionnaires were issued to each firm, one for each of the selected department. For each department the target respondent were the head of department or a staff in a management position. These were the respondents believed to have some insights in matters of credit management. The sampled respondents were
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therefore be 96 in total and were as follows:
Table 3. 1:Population and sample size
Population=44 insurance firms
Sample size=24
Sample size=55%
Insurance firms
44
24
55%
TOTAL
44
24
55%
Table 3. 2:Sample respondents
Department
Population=44 respondents
Sample respondents
Sample size=55%
Finance
44
24
55%
Credit department
44
24
55%
Sales/Underwriting department
44
24
55%
Claims department
44
24
55%
Total respondents
176
96
55%
Types of Data
According to Kothari (2004), primary data consists of data collected directly by the researcher through data collection tools such as questionnaires and interviews. On the other hand, secondary data consists of already documented data such as library books, newspapers and Internet files. In this context, the study used primary data collected through a questionnaire but also used secondary data as a source of literature review.
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Data Collecting Tools
There are various tools for data collecting but the main ones are interviews, observations and questionnaires, as discussed by Mugenda and Mugenda (2003).
An interview is an oral administration of a questionnaire or an interview schedule. One of the advantages of an interview is that they provide in-depth data which is not possible with a questionnaire, but they are more expensive to administer and are usually subjective (Mugenda & Mugenda, 2003).
Under observation method, personal interaction is not required. A researcher utilizes an observation checklist to record what he or she observes during data collection. This method is preferable as it permits the observer to spend time thinking about what is occurring rather than on how to record it and this enhances the accuracy of the study. However it limits the scope of enquiry as there is no opportunity for probing, is not free from bias and not easy to determine the degree to which the presence of the observer changes the situation under observation (Mugenda & Mugenda 2003).
According to Kumar (2005), a questionnaire is a written list of questions, the answers to which are recorded by respondents. In a questionnaire respondents read the questions, interpret what is expected and then write down the answers. The researcher used a questionnaire as a data collection tool. The questionnaire comprised both open and closed ended questions. The use of structured questionnaire ensures consistency of question and answers from the respondents. A questionnaire is more preferred by respondents due to anonymity. In addition, the use of a questionnaire saves a lot of research time as interview takes a lot of researcher’s time. Drop and pick questionnaires ensure that the researcher does not disrupt the respondents working schedule. According
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to Mugenda and Mugenda (2003) a questionnaire is one of the best tools of collecting primary data. In this study primary data was collected using a structured questionnaire, since it was easier to administer, analyze and economical in terms of time and money.
Data Collection Procedures
The researcher obtained permission to carry out the study from the Department of Research at the Daystar University. Additional permission to collect data was sought from the association of Kenya insurers (AKI).
Each questionnaire was preceded by a letter of introduction. The questionnaire was structured in a way to include both open and close ended questions.
In this study, the researcher needed to identify the degree by which respondents agree or disagree or simply the degree of response. Consequently, the addition of a likert scale to the self-report questionnaire was useful. According to Kumar (2005), the summated rating scale, more commonly known as the likert scale, is the easiest to construct and is based upon the assumption that each statement/item on the scale has equal ‘attitudinal value’, ‘importance’ or ‘weight’ in terms of reflecting an attitude towards the issue in question.
Questionnaire Pre-test
According to Mugenda and Mugenda (2003), once the questionnaire has been finalized it should be tried out in the field. The researcher did this by selecting a sample similar to the actual sample that was used in the study but subjects used for pre-testing were not used in the actual sample. The researcher considered 2 cases, which represented 5% of the sample size. According to Mugenda and Mugenda (2003) the number of cases in the pre-test should be between 1% and 10% depending on the sample size. The pre-
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test cases were selected among the 20 insurance firms not to be included in the sample. The aim of pretesting was to remove and amend vague questions, use respondent comments to improve the questionnaire, remove deficiencies and analyse a few questionnaires to see if the methods of analysis are appropriate.
Data Analysis
Data Analysis is the processing, editing and reducing accumulated data to a manageable size, developing summaries, looking for patterns, and applying statistical techniques (Cooper & Schindler, 2007). Further, Gay (1992) observed that data analysis involves organizing, accounting for and explaining the data; that is making sense of the data in terms of respondents definition of the situation noting patterns, themes, categories and regularities.
Once the questionnaire have been administered, the mass of raw data collected was systematically organized in a manner that facilitates analysis, through coding. To permit quantitative analysis, data was converted into numerical codes representing attributes or measurable through a coding process using a computer (Mugenda & Mugenda, 2003).
The data collected was analyzed by use of both inferential and descriptive statistics. The purpose of descriptive statistics was to enable the researcher to meaningfully describe a distribution of scores or measurements using a few indices or statistics (Mugenda & Mugenda 2003). In particular, frequencies, averages and percentages were used. The data analysis was through simple tabulation and presentation of report generated from spreadsheets such as excel. In addition the Statistical Package for Social Sciences (SPSS) and STATA were used.
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Regression analysis is a type of analysis used when a researcher is interested in finding out whether an independent variable predicts a given dependent variable. It is categorized into two, simple regression (where researcher is dealing with only one independent variable and one dependent variable) and multiple regression (attempts to determine whether a group of variables together predict a given dependent variable) (Mugenda & Mugenda, 2003). Regression analysis was used to demonstrate a relationship between trade credit management practices and competitive advantage.
Regression analysis also yields a statistic called coefficient of determination or R2. The R2 refers to the amount of variation explained by the independent variable or variables. If R2 is calculated to be 0.48 it means that 48% of the variation in a given dependent variable is explained or predicted by variables in the equation. The rest 52% cannot be explained by the variables in the equation (Mugenda & Mugenda, 2003).
Variables and Model Specification
To address the first research question, that is, the motives for offering trade credit among insurance firms in Kenya, the one sample test was used though Zainudin (2008) used descriptive statistics. It was hypothesized that the observed mean response for questions relating to motives is not significantly different from the hypothetical mean of 4.5 where 4.5 signifies “a strong agreement” to the questions.
To address the second research question, that is, whether there is a significant difference in trade credit management practices between small and large size firms, a different approach underlined below was used. First and foremost, the total assets (TA) derived from the sum of Net current assets and non-current assets of the 24 insurance companies represented the size of an insurance firm. The mean Total Assets of the
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insurance industry according to IRA is Kes 7billion .Therefore those insurance firms with Total Assets less than the mean TA were put in one group named “Small Size firms”. Those firms with a TA greater than the mean TA were put in another category of “Large sized firms”. In addition, the Average Collection Period (ACP) was taken as a proxy for trade credit management following Zainudin(2008). Though Zainudin(2008) advocated for the use of Kruskall-Walis test, we assumed normality of variables and used the two independent sample t test to test for the difference in means between “small size” and “ large size firms”. To support the above findings, the following regression model was used.
ACP = k+ TA+ e
Where:
ACP = Average Collection period
TA= Total Assets
K=constant
e’= error term
The third research question used regressional analysis to establish the relationship (association) between good trade management practices and competitive advantage. First and foremost, one sample test was used to test whether there is any significant difference between the observed mean response for questions relating to the questions on quality of ACP and a hypothetical mean of 4.5, where 4.5 signifies “strong agreement” in the likert scale. The same procedure was used in testing for competitive advantage with the only difference being that the hypothetical mean was 4.5 where 4.5 in the likert scale indicated strong agreement.
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To complement this test, a regresion analysis was carried out. The profit before tax (PBT) of the 24 insurance companies represented the competiveness of an insurance firm following Molina et al. (2004). In addition, following Zainudin (2008) a regression analysis where PBT is the dependent variable and ACP is the independent variable adopted the following form.
PBT= K+ ACP+e
Where:
PBT= Profit before tax
ACP= Average Collection Period
K= constant e’= error term
Source: Adapted from Zainudin(2008)
Data Presentation
The data was then presented using frequency distribution tables, graphs and charts. According to Kumar (2005), the main purpose of using data-display techniques is to make the findings clear and easily understood having analysed the data. Tables are the most common method of presenting analysed data, and they offer a useful means presenting large amounts of detailed information in a small space. In the study, we used both frequency tables and cross-tabulations (containing information about more than two variables).
The main objective of a graph is to present data in a way that is easy to understand and interpret, and interesting to look at it (Kumar, 2005). Graphic presentations often make it easier to see the pertinent features of a set of data. In this
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study made use of Bar Charts for displaying categorical data, histogram and frequency polygons. These tools were selected because of their ease of understanding and clarity in presentation.
Ethical Considerations
Ethics are norms or standards of behaviour that guide moral choices about our behaviour and relationship with others. The goal of ethics in research is to ensure that no one is harmed or suffers adverse consequences from research activities (Cooper & Schindler, 2007).
A letter was obtained from the Department of Research at Daystar University giving the researcher permission to conduct the research. The respondents of the study were assured of confidentiality of all information disclosed in the course of the research. This measure was taken to improve the response rate as well as to comply with the ethical issues relating to handling sensitive information. A copy of the research report was made available to the firm under study as well as the Daystar University Library.
Summary
This chapter detailed the methodology that was used in this study. It highlighted the research design, population, sampling design, samples and sampling techniques, data collection methods and procedures, data analysis, variables & model specifications, data presentation and ethical considerations.
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CHAPTER FOUR
Data Analysis and Results
This chapter discusses the results of the data analysis. The chapter attempt to analyse the study objectives namely; (i) To establish the motives for the supply of trade credit by Insurance companies in Kenya (ii) To establish whether the quality of trade credit management practices as measured by ACP differ between firms of different sizes (iii) Establish whether there is a relationship between the quality of trade credit management practice as measured by ACP and competitiveness of a firm and (iv) To compare the credit management practices in the insurance industry with the best practice and draw valid policy recommendations for improvement.
Response Rate
In this study a successful response rate implied that the questionnaires were returned fully filled, whereas the unsuccessful response rate implied that the questionnaires were either unreturned or returned but incompletely filled. Sixty seven (67) questionnaires out of 96 were filled and returned. Of the 67 returned questionnaires only 36 were fully completed and the rest 31 were partially complete. The successful response rate was therefore 38 percent and the unsuccessful response rate was 62 percent as reflected in Figure 4.1. Only the fully completed questionnaires were analyzed. A study by Kirema (2009) obtained a successful response rate of 30 percent which according to him was adequate to justify his study. Another study by Isaksson (2002) obtained a response rate of 35 percent which according to him was adequate to justify his study.
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Figure 4. 1:Response Rate
The data was analysed using statistical package for social sciences (SPSS) version 17 and the analysis is given below.
General Characteristics of the Respondents
Gender Response
Findings in this study indicated that the majority of the respondents were male at 67 percent and women at 33 percent as reflected in Figure 4.2. Though there was no discrimination in issuing out the questionnaire, and whereas every manager dealing with matters of trade credit had equal chance of being selected as a respondent, majority of the respondents were males. The finding implied that the insurance sector is male dominated at managerial level
Response rateSuccesful; 36; 38%Unsuccesful; 60; 62%
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Figure 4. 2:Gender Response
Department Response
The respondents by department were as follows; finance 28 percent, claims 28 percent, underwriting 25 percent and Credit department at 19 percent. The findings implied that the responses were fairly distributed across the departments thus the results obtained were unbiased.
Figure 4. 3: Department Response
Gender R esponse
F emale; 12;
33%
Male; 24;
67%
Department R esponse
C laims ; 10; 28%
F inance; 10; 28% C redit; 7; 19%
Underwriting; 9; 25%
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Education Response
The majority (70 percent) of respondents in this study were university graduates. Postgraduates were 8 percent while 22 percent had college level of education. The findings as reflected in Figure 4.4 implied that insurance companies employees were highly educated professionals. Consequently, this may have positively impacted on the quality of responses. These findings were in line with a study by Kitaka (2000) whose study respondents were mainly university graduates.
Figure 4. 4: Education Level
Age Bracket
The majority of respondents 72 percent were aged between 31 to 40 years. This finding implied that the respondents of the study were mature, energetic and highly productive individuals considering that between 30-50 years is the most productive age.
This finding further implied that the insurance industry has a stable work group at managerial level. The findings were consistent with those of Isaksson (2002) whose
Education LevelCollege; 8; 22%Post Graduate; 3; 8%University Graduate; 25; 70%
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majority of respondents were between the age of 31 to 40. The findings are presented below.
Figure 4. 5: Age Bracket
Nature of Products
The majority of respondents 47 percent indicated that the insurance companies mainly offered composite type of insurance. Meanwhile, 42 percent and 11 percent of respondents indicated that the other products offered were General and Life insurance. The findings are presented below.
Age Bracket26; 72%5; 14%4; 11% 1; 3%21-3031-4041-50Over 50
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Figure 4. 6: Nature of Product
Tests for Normality
Having understood the general characteristics of the respondents, the research study now presents the empirical data about the companies industry. The Skewness and Kurtosis tests for Normality were tested on the collected data using SPSS. The aim of a skew test is to indicate whether each variable is skewed to the left or skewed to the right or if it is normally distributed. For the normally distributed series, the expectation is that the skewness coefficient ranges from -2 to +2. The result of the skewness test are tabulated in table 4.1 below. All the variables were normally distributed as their coefficients ranged from -2 to +2.
Kurtosis is an indicator used in distribution analysis as a sign of flattening or "peakedness" of a distribution. A kurtosis with a value of less than 2 indicates a platykurtic distribution, flatter than a normal distribution with a wider peak. The probability for extreme values is less than for a normal distribution, and the values are
Product offeredComposite; 17; 47%General; 15; 42%Life; 4; 11%
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wider spread around the mean. The result of the kurtosis test is also tabulated n table 4.1 below. As observed from table 4.1 variables (TA and ACP) exhibited a platykurtic distribution. However, the PBT variable exhibits a leptokurtic distribution as its kurtosis was greater than 2. A leptokurtic distribution is sharper than a normal distribution, with values concentrated around the mean and thicker tails. This means high probability for extreme values.
Table 4. 1: Skewness/Kurtosis tests for Normality
Descriptive Statistics
N
Mean
Skewness
Kurtosis
Statistic
Statistic
Statistic
Std. Error
Statistic
Std. Error
TA
24
6864.58333
1.26300488
0.472261
0.232006
0.917777
PBT
24
376.6666667
1.69143734
0.472261
2.570949
0.917777
ACP
24
59.26666667
-0.1823938
0.472261
-0.78314
0.917777
Motives for Advancing Trade Credit
One of the objectives of the study was to establish the motives for the supply of trade credit by Insurance companies in Kenya. The null hypotheses for this objective were that the motives of for the supply of trade credit by Insurance companies in Kenya are ; a) To attract and retain customers b) To minimize the costs of frequent transactions c) To achieve economies of scale through centralization of the credit d) To assist a customer in financial distress e) To guarantee the quality of the service f) Because the firm can gather up to date information about a customer at low costs g) Because the firm can threaten not to pay claims until full premium payment.
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The findings reflected on the table 2, indicates a p-value of 0.939. This implies that there is very high probability (93.9 percent) that the difference between the observed mean of 4.396 and the hypothetical mean were by chance and hence no significant difference between the means. In other words there is a very high probability that the null hypothesis is true and therefore the study accepts the hypotheses.
This finding were consistent with the theoretical review by Deloof and Jegers (1999) which asserted that from the perspective of uncertain buyers, trade credit is an implicit guarantee by the seller of the product quality. The findings were also consistent with financing theory of trade credit advanced by Evans (1998) who posited that suppliers desirous of maintaining a long-term product market relationship grant more concessions to a customer in financial distress, as compared to similarly positioned lending institutions.
The findings are also consistent with transactions cost theory by Bhattacharya 2008) which argues that rather than paying bills every time goods are delivered, a buyer might want to cumulate obligations and pay them only monthly or quarterly in order to reduce the frequency of transactions and the associated costs.
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Table 4. 2: Motives for advancing Trade Credit One-Sample Test Test Value = 4.4 T Df Sig. (2-tailed) Mean Difference 95% Confidence Interval of the Difference Lower Upper MOTIVES -.077 35 .939 -.0032 -.0874 .0810
ACP and Firm size
Another objective of the study was to establish whether trade credit management practices (ACP) differs between small and large insurance firms. The null hypothesis was that there is no significant difference between the ACP of the large firms and small firms. From the t-test, p= 0.00 (which is

References: from financial institutions. The inability of financial institutions to fully evaluate the risk for small and medium firms makes them unwilling to release funds to the sector (Cosh & Hughes, 1994). September 20, 2010). Trade credit has become a strategic competitive tool for many companies in the industry. The only available option left for many companies was to aggressively collect the outstanding premium. As previously observed by Peel et al. (2000) focus was only given 9 The magnitude of the debt problem is further affirmed by IRA report that showed that the industry was owed Kenya Shillings 8 Billions of unremitted premium by 31st December 2009 (IRA, 2009).