A Pure Financial Explanation for Trade Credit

Abstract

This paper provided a pure financial explanation for the existence of trade credit and for the values of the credit terms offered to customers. Two motives for extending trade credit were identified. The pure operating flexibility motive arises because the opportunity to change credit policy provides the seller an efficient way to respond to fluctuations in demand. This motive was eliminated from consideration in this paper by assuming constant demand. The seller must hold a liquid reserve when the financial markets are imperfect and the desire to earn an excess rate of return on this reserve explains the pure financial intermediary motive for trade credit.The pure financial incentive to lend this liquid reserve to customers was examined by viewing a market borrowing rate of interest that exceeds the market lending rate of interest as a hindrance to trade or, equivalently, as a financial market tariff. This tariff imposes a wedge between the market prices paid and received for the product plus a loan and thereby inflicts a loss of surplus on the seller and buyers. Trade credit lending enables the seller and/or the buyers to recapture at least part of this loss when the source of the tariff does not apply to direct loans to customers. Financial market tariffs caused by transactions costs fulfill this requirement because the trade credit lender's familiarity with its customers and product provide it with information and collection cost advantages over financial intermediaries. Tariffs caused by financial intermediary rents fulfill this requirement as well because the parties to a trade credit loan do not employ the services of a financial intermediary.Increasing opportunity costs and financial market imperfections in addition to the ones described above establish the limits of credit policy. The optimal amount of accounts receivable is derived from the condition that the marginal revenue of trade credit lending is equal to the marginal cost. This condition combined with factoring costs produces a unique, finite optimal credit period. Accrual accounting for income tax purposes imposes an additional restriction because the firm is taxed on the recovery of its opportunity costs. These limitations on credit policy were examined separately in this paper for clarity but they are in effect simultaneously in practice.