Letters of credit could help resolve late payments crisis

Meru Contractors Association chairman Stephen Nturibi addresses the media over payments dispute with the county government on May 15. PHOTO | DAVID MUCHUI
Meru Contractors Association chairman Stephen Nturibi addresses the media over payments dispute with the county government on May 15. PHOTO | DAVID MUCHUI 

Kenya’s culture of late payments is preventing businesses— especially small and medium-sized enterprises (SMEs)—from investing in growth and contributing to economic recovery.

There can be no denying the fact that cash flow is the lifeblood of any business.  Businesses need cash to buy supplies, pay employees, service debt and invest in equipment and training.

Ordinarily when trading with government, suppliers usually make sales on credit, receiving payment only after they have supplied goods or services and invoiced.  Payment is normally due within an agreed number of days after the invoice date. 

The fact is that businesses incur the cost of providing goods and services upfront. 

Being paid on time is very important. If payment is not received within the agreed payment period, the supplier incurs additional costs chasing payment. Reduced cash flow may mean planned investment in the business cannot go ahead and may prompt the need to borrow more.

In extreme cases, late payment does result in a profitable business going bust and this has a knock-on effect, triggering the insolvency of other enterprises further down the supply chain. To avoid the downsides of late payment, businesses may be able to use a factoring service, which, for a fee, will exchange unpaid invoices for cash.

This can be especially attractive where the agreed payment terms are long. However, when using a factor, the supplier suffers a discount on the value of the unpaid invoice.

SMEs are particularly vulnerable to slow payment because they often lack access to alternative sources of finance to cover delays in payment.  At the same time, they tend to have little scope to demand timely payment from the larger businesses and the government that they supply because they rely on the continuing custom of those businesses to survive.

Paying the government’s suppliers promptly brings financial benefits, enabling businesses to reduce their overdrafts, thereby reducing their interest payments. 

It also reduces the cost to businesses chasing public sector bodies for payment of overdue invoices, and the wider economy benefits from fewer failed businesses.

As it stands trading with government involves risks. Suppliers run the risk of government delaying or failing to pay for goods and services, while government risks paying but never receiving anything.

One way of reducing the risks is for government to adopt several different types of letters of credit — to guarantee suppliers that they will be paid, and the government that no payment will be made until it receives the goods and services. 

A letter of credit is basically a guarantee from a bank that a particular seller will receive a payment due from a particular buyer. The bank guarantees that the seller will receive a specified amount of money within a specified time.  

In return for guaranteeing the payment, the bank will require that strict terms be met. It will want to receive certain documents — for example signed delivery notes — as proof.

The main advantage of using a letter of credit is that it can give security to both the seller and the buyer.

By asking for an appropriate letter of credit a seller is reassured that they will receive their money in full and on time.

A letter of credit is one of the most secure methods of payment for suppliers as long as they meet all the terms and conditions. The risk of non-payment is transferred from the seller to the bank (or banks).

When the government uses a letter of credit it gets a guarantee that the seller will honour their side of the deal and provide documentary proof of this.

It’s important to be aware of the additional costs involved in using a letter of credit. Banks make charges for providing them, so it’s sensible to weigh up the costs against the security benefits.

From the onset the supplier will be aware that they will only receive payment if they keep to the strict terms of the letter of credit. They will need to give documentary proof that they have supplied exactly what government contracted them to supply.  

This is a better alternative than no knowing whether they will be paid.

Ommes is Director at Sphere Business Africa Limited. [email protected]