Trade Receivables Policy of Distressed Firms and Its Effect on the Costs of Financial Distress
Molina, Carlos A., Preve, Lorenzo A., Financial Management
This paper studies the trade receivables policy of distressed firms as the trade-off between the firm's willingness to gain sales and the firm's need for cash. We find that firms increase trade receivables when they have profitability problems, but reduce trade receivables when they have cash flow problems. We also find that a firm that significantly cuts its trade receivables when in financial distress will experience an additional drop of at least 13% in sales and stock returns over the previously documented 20% average drop for financially troubled firms. Moreover, the performance decline of a firm in financial distress is significantly higher if the firm cuts trade receivables than if it does not.
Trade receivables are a large part of firms' assets. Mian and Smith (1992) report that 21% of the total assets of US manufacturing firms in 1986 were invested in financing clients. Deloof (2003) documents that 17% of the total assets of Belgian firms in 1997 were account receivables. The management of trade receivables, given its importance for firms' assets, has the potential to play an important role when firms encounter financial problems. Previous studies have focused on the estimation of the costs of financial distress (Altman, 1984; Alderson and Betker, 1995; Andrade and Kaplan, 1998; Molina, 2005), in some cases explicitly recognizing the importance of the relations with clients for capital structure decisions and for the costs of financial distress (Titman, 1984; Opler and Titman, 1994). One question that has not been considered before, however, is how troubled firms, and the costs of their financial distress, may be affected by their trade receivables policy.
In this paper, we address two questions. First, we study the trade receivables policy of a firm in financial distress as the trade-off between the firm's willingness to gain sales by financing its clients' purchases and the firm's need for cash. Second, we measure the effect of suboptimal trade receivables investment policies on the costs of financial distress. Financing clients via trade receivables can be seen as a short-term investment to capture clients, and we know that firms in financial distress are expected to underinvest. (1) Consistent with this intuition, Mian and Smith (1992) find that firms with lower bond ratings increase the use of factoring to manage their accounts receivables, suggesting that they are willing to collect their receivables faster as the quality of their ratings decreases. In contrast, Petersen and Rajan (1997) find that firms whose sales drop and firms with negative profits increase trade receivables to their clients. They argue that this increase might be due to a voluntary attempt to gain market share and sales or to an unwanted increase in receivables given the impaired ability of troubled firms to enforce the timely collection of their commercial credit. If this last interpretation is correct, the increase in receivables could be considered a cost of financial distress. Trying to buy market share by extending additional financing to clients may seem appealing to a troubled firm, as Petersen and Rajan (1997) suggest, but this strategy can be very costly, especially for those firms whose access to financial credit is severely curtailed.
To reconcile these two seemingly contradictory views, we explore the nature of the financial distress problem in greater detail by defining it in two different stages: 1) firms facing profitability problems, usually at the prefinancial distress stage and 2) firms facing cash flow problems, usually in full-blown financial distress. We study and compare the trade receivables policy of firms in both groups. We argue that firms facing profitability problems may attempt to apply an aggressive credit policy to clients in order to gain market share, especially if they have the market power to do so without incurring significant sales losses. Firms facing cash flow problems, however, should try to decrease their investment in clients' credit in order to get cash, especially if they can afford to do so without relinquishing an excess of their sales volume to their competitors. …