Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Trade Credit: Why Do Production Firms Act as Financial Intermediaries?

Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Trade Credit: Why Do Production Firms Act as Financial Intermediaries?

Article excerpt

The United States has the most highly developed financial markets in the world. Yet, trade credit--credit granted by a selling firm to finance another firm's purchase of the seller's goods remains the single largest source of short-term business credit. Despite its importance as a mechanism for financing inter-firm trade, trade credit receives less attention in the business press than developments in bank lending markets or corporate debt markets. But the key role of trade credit asserts itself whenever a well-known firm suffers severe financial problems. When a firm's suppliers begin to demand cash on delivery, the business press begins to speculate on whether the firm is headed for bankruptcy.

The numbers attest that trade credit plays a large role in firms' finance. One way to measure this is to look at firms as borrowers. Mitchell Petersen and Raghuram Rajan's 1997 article shows that accounts payable--funds owed by the firms in their sample to trade creditors--average 4.4 percent of sales for a sample of small U.S. firms and 11.6 percent of sales for a sample of large U.S. firms. (1) Another way to measure this is to look at firms as lenders, that is, to look at accounts receivable funds owed to the firms in the sample by their customers. Accounts receivable represent nearly 7.3 percent of sales for small firms and 18.5 percent of sales for large firms. (2)

Firms in most other industrialized nations are comparably reliant on trade credit. Raghuram Rajan and Luigi Zingales report that in the G-7 nations, (3) accounts payable of a sample of large firms range from 17 percent of assets in France to 11.5 percent of assets in Germany--compared with 15 percent of assets for U.S. firms. (4) Accounts receivable range from 13.0 percent of assets in Canada to 29 percent of assets in France and Italy compared with 17.8 percent in the U.S. (5) Data from the less developed world suggest that trade credit may be even more important for such nations.

Remarkably, until Petersen and Rajan's empirical work in the 1990s, economists could offer only sketchy, anecdotal answers to the most elementary questions about trade credit: Who offers trade credit? Who takes trade credit? While their work made a giant step forward, getting some of the facts straight is only the first, necessary step in answering a basic question that occurs to any economist who thinks about trade credit: Why should a firm that specializes in production or sales act as a financial intermediary when specialized intermediaries like banks can (and do) provide working capital finance? Most puzzling, why should a firm borrow short term from a bank, then provide short-term credit to its customers? Why not cut out the middleman? (6)

While financial economists have proposed a number of explanations, I focus on those explanations that view trade credit as a method of monitoring and enforcing loan contracts to relatively risky firms. I also examine the explanations that hinge on the benefits of long-term supply relationships as an underpinning for flexible and differentiated credit decisions.


Consider Stocking Out, a fast-growing retail hosiery emporium with six outlets in the Philadelphia suburbs, and one' of its major input suppliers Run/Don't Run (R/DR), a manufacturer of top-of-the-line athletic socks. R/DR makes a large monthly delivery of socks, and it may take anywhere from a few hours to a few weeks to sell the socks once they are on the shelves. Until the socks are sold, Stocking Out counts them as inventory on its books. How might Stocking Out pay for the unsold goods until the revenues from selling them arrive? The main possibilities are illustrated in the figure.


Banks Offer Working

Capital Loans. One possibility is that Stocking Out takes out a working capital loan--a loan to finance inventories--from a bank and pays R/DR directly. The most typical arrangement is a revolving loan commitment, in which the bank sets a credit limit and the firm draws down and repays loans at prearranged terms, much like a credit card. …

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