The primary rationale for demanding trade credit (loans from suppliers in the form of buy-now-pay-later schemes), has to do with limited availability of financing. If you run a small firm, your local may charge you a high rate on loans because it doesn’t know and/or trust you. You may be too risky. However, your supplier may have several reasons to give you a better deal: (1) it knows you better than your bank, (2) it worries about the lost sales that would result in your bankruptcy (suppose your small business is fundamentally sound in the long run, but cash is a little tight at the moment), and (3) your supplier hopes you will grow and wants to develop a good relationship now.
For such a “credit transfer” to make sense, the supplier must have lower costs of credit than the customer, and the customer must be financially constrained.
Other theories of trade credit revolve around signals or product and firm quality:
- A business may advertise its confidence in the quality of its products by offering to ship weeks or even months before requiring payment, in order to give the customer a zero-risk trial period.
- A bank may want to see accounts payable on a loan applicant’s balance sheet as evidence that another informed party is also willing to extend credit.
- In addition to Suppliers observe customers’ amounts and frequencies of purchases, and supplier-creditors also observe any changes in the speed of payment. As a related party with a financial interest in the fortunes of a customer (much like an equity holder), suppliers may be willing to extend attractive credit terms to their customers–even if the supplier bears the cost–in order to gain this information.
None of these theories are able to predict a more recent pattern of increased trade credit borrowing on the part of large customers, who have good credit quality and do not appear to be financially constrained. Another reason a firm may borrow from its suppliers (begin paying them later) is because it is suffering from late payments from its customers. A rise in trade credit may be a firm’s way of passing the buck up the supply chain.
To look at more fundamental reasons for an expansion of trade credit, I help mitigate this concern by looking at a sample of 731 firms in industries at the end of the supply chain. Firms in these industries sell mostly to households (mostly final goods firms), which typically have low bargaining power, and they are also more likely to sell in cash transactions. From these firms, I identify 29 instance of changes in a firm’s supplier-payment policy, indicated by a dramatic increase in days payables outstanding (DPO). DPO is the ratio of accounts payable to cost of goods sold multiplied by the number of days in the reporting period, and it roughly captures the average number of days between the transaction in goods/services and the financial transaction.
For each policy change, I measure the firm’s average financial situation for the four quarters preceding the policy change, for each of the 1, 2, 3, 4, and 5 years after the change, and for the entire 5-year post-change period. I also measure the firm’s percentile within its industry during each of these period, where industry is defined as 4-digit SIC code. A fragment of Table 10 (below) illustrates the basic findings of this exercise. By construction, all percentiles fall between zero and one. Low (high) percentiles are highlighted in red (green).
A few striking patterns emerge:
- Just before instituting a major change in supplier payment policy, these firms tend to pay much faster than their peers, with DPO at the 31st percentile. This may put them at a disadvantage to their peers who have more working capital financed by their own suppliers. This may also be a major reason behind the change. Post-change, these firms pay slower than most of their peers, with DPO at the 70th percentile.
- If these firms intentionally overshoot their median peers, it suggests a ratchet effect in trade credit, where no competitor wants to be below average.
- A major cross-sectional shift also occurs in the amount of credit these firms extend to their customers. Before the policy changes, the firms’ DSO (days sales outstanding, or the ratio or accounts receivable to cost of goods sold) is at the 30th percentile, on average. After the change, it is at the 70th percentile.
- Even while the new, slower payment policy may be bad for the firm’s suppliers, it may also be good for the firm’s customers. If these are households, then this would suggest a wealth transfer from these firms’ suppliers to households.
- There is no evidence that these firms are financially constrained before the policy change. The average policy-changing firm has higher-than-median cash, cash flow, and profitability. It has relatively low leverage and a very high interest coverage ratio (the ratio of EBITDA to total interest payment). Modified interest coverage adds the total of short-term debt to the denominator of the coverage ratio, as a sort of “stress test” for situations in which short-term credit become temporarily unavailable. These policy-changing firms also tend to be much larger than the average or median Compustat firms. In the years 2008-2016, the average (median) Compustat firm had $2.8 billion ($504 million) in assets, while these firms have an average of $3.7 billion in assets just before the policy change. This would put the average policy-changer in my sample just above the 80th percentile in Compustat in the past decade.