Shareholder Returns from Supplying Trade Credit

We examine shareholder wealth implications of supplying financing to customers. Robust results suggest that excess returns and changes in trade receivables are directly and significantly related. Further evidence indicates the value of receivables is higher for suppliers with stronger motives relating to operating and contracting costs. The results also suggest a discounted value of receivables for financially unconstrained firms. Overall, we conclude that investors recognize trade credit as an effective instrument in mitigating frictions hindering sales growth. Thus, certain suppliers are positioned to derive increased strategic benefits from credit policy. Providing trade credit is important to many suppliers whose future sales and nonsalvageable relationship-specific investments depend on customers’ financing ability (Smith, 1987). Nadiri (1969) emphasizes the role of supplier financing by comparing trade credit to a capital investment that yields returns over time through gains in market share. Although Kim and Atkins (1978) and Sartoris and Hill (1981, 1983) demonstrate theoretically the impact of trade credit policies on suppliers’ firm value, the literature lacks an empirical examination of this impact. This study seeks to fill this void by estimating the shareholder wealth effects of providing financing to customers. The volume of accounts receivable held by publicly traded firms warrants a better understanding of its influence on equity values. For our sample, the average firm’s investment in receivables is roughly $360 million and the mean receivables-to-assets ratio is 18%. These statistics echo findings in previous studies (Mian and Smith, 1992; Molina and Preve, 2009) and reiterate the important role of trade credit in the US economy. Our results indicate a direct and economically significant relation between shareholder wealth and trade receivables. This is consistent with investors recognizing the future revenue growth associated with lending to customers and the liquidity reserve provided by receivables (Emery, 1984). Estimates for the market value of an additional dollar in receivables is significantly less than for a marginal dollar in cash, as theory predicts given the additional costs in carrying and/or liquidating receivables. Quantitative and qualitative inferences are robust to firm-specific heterogeneity and after redefining the receivables measure. 255 Matthew D. Hill is an Assistant Professor and the J. Ed Turner Chair of Real Estate in the Department of Finance at the University of Mississippi, University, Mississippi. G. Wayne Kelly is an Associate Professor in the Department of Finance, Real Estate, and Business Law at the University of Southern Mississippi, Hattiesburg, Mississippi. G. Brandon Lockhart is an Assistant Professor in the Department of Finance at the University of Nebraska–Lincoln, Lincoln, Nebraska. We thank two anonymous referees for Financial Management, and Janet Kiholm Smith, Lorenzo Preve (Discussant), Bill Christie (Editor), and conference seminar participants at the 2010 FMA Annual Meeting (New York) for helpful comments and suggestions. 256 Hi l l , Ke l ly , & lo c K H a r t i n Fi n a n c i a l Ma n a g e M e n t 41 (2012) Additional results show that certain product market characteristics govern the market value of trade receivables. Specifically, the value of supplier financing increases with sales volatility, supporting Emery’s (1987) view that sales queues reduce the costs of storing inventory and altering plant capacity. Further evidence suggests the equity market perceives the product quality motive of trade credit. The value of receivables significantly decreases (increases) with reputational capital (research and development [R&D] expenditures). Results also support differences in the value of supplier financing across industries. We do not find that the length of the production cycle influences the relationship between excess returns and changes in receivables. We also examine the influence of financial constraint on the value of receivables. Results indicate investors discount the receivables of unconstrained firms, despite the likelihood that these firms have cost advantages in extending trade credit. This finding is consistent with the equity market viewing receivables as a substitute for cash, at least within the financial constraint paradigm. In addition, we find that the value of receivables is unrelated to prior period cash holdings, but decreases significantly with leverage levels. This research extends the trade credit literature by linking firms’ motives in extending trade credit to the equity market’s assessment of these motives. Several studies examine the determinants of supplier financing, focusing on the preferences, and expectations of both buyers and suppliers.1 Our approach connects excess stock returns to changes in receivables, providing evidence that trade credit policy is valued by shareholders. Further, our value approach provides a novel examination of the motives underlying trade credit extension, which is important as firms may use capital market proceeds to finance receivables. Overall, variation in the market value of receivables across product market characteristics and financial constraint is consistent with the existing research suggesting the various strategic dimensions of trade credit in enhancing firm value (Petersen and Rajan, 1997). A related study by Molina and Preve (2009) examines reductions in trade credit as an additional cost of financial distress and finds that performance is negatively related to the interaction between financial distress and extreme reductions in trade credit supplied. Our results and contributions are unique in that we examine the link between shareholder wealth and typical trade credit behavior. We do not limit our focus to extreme reductions in trade credit as a consequence of distress. Further differentiating this study, we find that the degree to which suppliers can use trade credit to increase shareholder wealth varies with product market dynamics and financial constraints. Thus, firms and financial analysts alike should consider these characteristics when assessing the efficiency of trade credit policies and behavior. We also extend the working capital management literature. Shin and Soenen (1998) and Deloof (2003) examine the relation between operating performance and the length of time funds are invested in the operating cycle, leaving the isolated value implications of receivables unexamined. Although the value of cash holdings is the focus of many studies in the cash management literature, the market value of trade credit is absent, despite the margin by which investments in receivables exceed cash holdings for our mean sample firm.2,3 1. Research empirically examining the determinants of trade credit extension include Nadiri (1969), Deloof and Jegers (1996), Petersen and Rajan (1997), Love, Preve, and Sarria-Allende (2007), Giannetti, Burkart, and Ellingsen (2008), Bougheas, Mateut, and Mizen (2009), Molina and Preve (2009), and Garcia-Teruel and Martinez-Solano (2010). 2. Existing research examines various issues associated with the market value of cash. Faulkender and Wang (2006) and Denis and Sibilkov (2010) find that the value of cash is reduced for less financially constrained firms. Pinkowitz, Stulz, and Williamson (2006) demonstrate how political corruption reduces the marginal value of cash for international firms, although Dittmar and Mahrt-Smith (2007) report that weakened governance reduces the value of cash for US firms. Klasa, Maxwell, and Ortiz-Molina (2009) find the value of cash decreases with increased unionization rates. 3. Our sample has mean cash-to-assets and receivable-to-assets ratios of 13% and 18%, respectively. SH a r e H o l d e r re t u r n S f r o m Su p p ly i n g tr a d e cr e d i t 257 The paper proceeds as follows. Section I outlines theoretical underpinnings and specifies the model, whereas Section II describes the sample. Section III presents multivariate results and Section IV provides our conclusions.