How Inventory Is (Should Be) Financed: Trade Credit in Supply Chains with Demand Uncertainty and Costs of Financial Distress

As an integrated part of a supply contract, trade credit has intrinsic connections with supply chain contracting and inventory management. Using a stylized model that explicitly captures the interaction of firms’ operations decisions and financial risks, this paper attempts to develop a deeper understanding of trade credit from an operational perspective. Revolving around the question of what role trade credit plays in channel coordination and inventory financing,* we demonstrate that with demand uncertainty, trade credit enhances supply chain efficiency by serving as a risk-sharing mechanism. Two forces determine the optimal trade credit terms: the sales motive (increasing sales through risk-sharing) and the financing motive (minimizing costs of financial distress through financial diversification, that is, employing multiple financing sources). Facing a trade credit contract, the retailer finances his inventory using a portfolio of cash, trade credit, and short-term debt, and the structure of this inventory financing portfolio depends on the retailer’s leverage and bargaining power. Additionally, our model suggests that financial diversification provides an alternative explanation for the decentralization of some supply chains and the use of factoring in accounts receivable management. Finally, using a sample of firm-level data from Compustat, we find that the inventory financing pattern our model predicts exists in a wide range of firms.