Trade credit, cash holdings, and product market competition

Abstract

We examine how trade credit complements cash holdings in product market competition and find empirical support for this view. First, in line with the redistribution view of trade credit, we show that trade credit is sensitive to cash flows. Second, using an augmented Faulkender and Wang (2006) model, we report that stock market values both cash holdings and trade credit. Third, we identify that three common factors, namely, firms’ financial strength, market power, and relationship specific investments, moderate the valuations of cash and trade credit. For robustness, we use the U.S. import tariff reductions as exogenous shocks to product market competition and help establish causality between trade credit practice and competition. Overall, our findings strongly support the notion that corporate cash holding and trade credit decisions are intertwined. Managers be mindful of the trade-off between holding cash vis-à-vis distributing liquidity via trade credit.