Commercial Credit

Commercial Credit (also known as 'Trade Credit') is the grease that keeps the wheels of business-to-business (B2B) commerce spinning smoothly. In simple terms, it's a short-term loan extended from one business to another, allowing the buyer to purchase goods or services now and pay for them later. Instead of a customer pulling out a credit card, the seller issues an invoice with payment terms like “net 30,” meaning the bill is due in 30 days. This isn't just a matter of convenience; it's a fundamental part of how businesses manage their cash flow. For the seller, it's a tool to attract and retain customers. For the buyer, it provides the flexibility to generate revenue from the goods before having to pay for them. For a savvy value investor, analyzing a company's use of commercial credit—both given and received—is like peeking under the hood of a car. It reveals deep insights into a company's operational efficiency, its relationships with customers and suppliers, and its overall competitive strength.

On a company's balance sheet, commercial credit appears in two main places: as Accounts Receivable (money owed to the company) and Accounts Payable (money the company owes to others). Looking at the size and trend of these two accounts can tell you a fascinating story.

When a company extends credit to its customers, that money sits in Accounts Receivable. It's an asset, but it's an IOU, not cold, hard cash.

• What to watch for: A key red flag is when Accounts Receivable consistently grows much faster than revenue. This might signal that the company is desperately trying to make sales by offering overly generous terms to weak customers who may struggle to pay. This practice, known as “channel stuffing,” can create a short-term illusion of growth but often leads to future write-offs.
• The metric to use: To measure this efficiency, analysts use Days Sales Outstanding (DSO). It tells you the average number of days it takes a company to collect payment after a sale has been made. A low and stable DSO is fantastic, suggesting the company has strong customers who pay promptly. A high or rapidly increasing DSO warrants a much closer look.

This is where things get really interesting for a value investor. Accounts Payable represents the credit a company gets from its suppliers. Think of it as an interest-free loan!

• What to watch for: A large and growing Accounts Payable can be a sign of immense business strength. It means suppliers are so eager to do business with the company that they are willing to wait longer to get paid. This supplier-funded cash is a form of 'Float', a concept famously leveraged by Warren Buffett. The company can use this cash for its own operations, investments, or anything else before the bill comes due.
• The metric to use: The counterpart to DSO is Days Payable Outstanding (DPO). This calculates the average number of days a company takes to pay its own bills. A high DPO often indicates strong bargaining power with suppliers. For example, a giant retailer like Walmart can dictate payment terms to its suppliers, effectively using them as a source of financing.

To get a holistic view, investors combine these metrics into the Cash Conversion Cycle (CCC). The CCC measures how long it takes for a company to convert its investments in inventory and other resources into cash from sales. The formula is: CCC = Days Inventory Outstanding (DIO) + DSO - DPO A lower number is better, as it means the company needs less cash tied up in Working Capital. The holy grail is a negative CCC. A company with a negative CCC (like Amazon in its glory days) collects cash from its customers before it has to pay its suppliers. It's a self-funding business model—a true cash-generating machine!

When analyzing a company, don't just look at the income statement. Dig into the balance sheet and ask these questions about its commercial credit:

• Receivables vs. Revenue: Is Accounts Receivable growing in line with or slower than revenue? Be cautious if it's growing much faster.
• Payables Power: Does the company have a high Days Payable Outstanding (DPO) compared to its peers? This suggests a strong competitive position.
• Cash Machine Status: What does the Cash Conversion Cycle look like? Is it low, stable, and preferably negative? This signals outstanding operational efficiency.