The Effect of Trade Credit on Operational Policies and on the Relationship Between Banks, Suppliers, and Manufacturers.

Abstract

Companies in a broad range of industries and economies rely heavily on external sources to finance their operations. But, external financing could be expensive and/or difficult to obtain due to imperfections in real capital markets.

I focus on cash-constrained manufacturers that rely on external sources to finance their operations. More specifically, I focus on trade credit, the most important source of short-term financing, and analyze its effect on operational policies and on the relationship between banks, suppliers, and manufacturers. I discuss factors that affect supply reliability, fixed cost to work with a supplier, and the trade credit amount suppliers make available to manufacturers. Then, I determine how supply risk, financing constraints, and the dual role served by suppliers affect the financing and operational decisions of manufacturers. I also contrast differences in supply reliability, fixed cost to work with a supplier, and financing constraints between manufacturers in developed and developing economies to address how the economic environment manufacturers operate in affects their financing and operational decisions. Afterwards, I analyze the effect of trade credit on manufacturers' financing and operational decisions when there is information asymmetry between banks and manufacturers about the credibility of manufacturers.

The analysis suggests that the optimal number of suppliers may increase as the availability of either internal financing or trade credit diminishes and as the cost to work with a supplier or the wholesale price increases. Surprisingly, as the standard deviation of a supplier yield's increases, the optimal number of suppliers could either increase or decrease. Ceteris paribus, manufacturers in developing economies will have more suppliers than comparable manufacturers in developed economies. But if, in developing economies, the cost to work with a supplier is very high or the manufacturer is close to bankruptcy, then this manufacturer may actually have fewer suppliers than its counterpart in developed economies. Cash-constrained manufacturers should only use trade-credit to finance their operations when borrowing from suppliers is cheap or when they are trying to signal their credibility to banks. Also, the availability of trade credit may increase or decrease operational costs and it may increase the total amount to borrow.