Financial distress, free cash flow, and interfirm payment network: Evidence from an agent‐based model

Abstract

AbstractThis paper provides theoretical evidence about financial distress in the business sector in relation to firms' targeted free cash flow (FCF). An agent‐based model of a pure market economy is designed so that a population of firms interact with one another and with a bank. The model determines the interfirm payment network arising from supplier–customer relationships on the basis of a random graph with uniform attachment mechanisms. The interfirm payment network shapes both the liquidity available to each firm and the debts firms incur to finance these payments. Eventually, firms might not have sufficient liquidity to meet their debt requirements, hence their financial distress. Firms that target higher FCFs must reduce their payments to suppliers for the same amount of payments they expect to receive from customers. This influences the interfirm payment network and, therefore, firms' financial distress. On this basis, computational experiments introduce variations in FCF targets. The lowest FCF targets lead to the lowest levels of financial distress in the business sector. Our simplified case of interactions opens the way for further research that employs more complex agent‐based models.