Q&A - What is credit and why do businesses need it?

Credit is the lifeblood of any business - it is very difficult for a business to survive, and certainly grow without it. But what is credit?

Some small businesses trade in cash – and nothing else. Customers pay in cash and the expenses and costs of the business are settled in cash. There is no need for credit.

However, most businesses cannot survive simply with the cash they have in the bank or which they take from customers. They need to borrow or lend from banks, suppliers and others in order to trade.

So in business, credit is about borrowing – owing money to others for a period of time.

For example, credit arises when:

• A business makes use of a bank overdraft facility – e.g. the bank account goes £50,000 “into the red” or overdrawn
• A business takes out a bank loan – e.g. £100,000 loaned over five years
• A business buys goods or services from a supplier and agrees to pay for them in 30 days – known as trade credit

The amount of credit that a business can raise will depend on several factors such as:

• Whether the business is profitable and is likely to remain so in the future
• The ability of the business to generate a positive cash flow to allow it to repay credit
• The strength of the relationship between the business and its creditors
• The industry or market in which the business operates

You may have heard about the “credit crunch” during 2008 and 2009. The credit crunch was about a reduction in the availability of credit for businesses. As lenders struggled to stay in business, they lost confidence in the ability of businesses to repay credit. So many businesses found themselves in financial trouble due to:

• Banks withdrawing or lowering overdraft facilities
• Banks refusing to provide bank loans, or making the repayments and interest charges worse
• Suppliers insisting on earlier payment of invoices

The effects of the credit crunch – notably an increase in failed businesses – show just how important credit is to the business community.