Trade Credit, Risk Sharing, and Inventory Financing Portfolios

Abstract

As an integrated part of a supply contract, trade credit has intrinsic connections with supply chain coordination and inventory management. Using a model that explicitly captures the interaction of firms' operations decisions, financial constraints, and multiple external financing channels (bank loans and trade credit), this paper attempts to develop a deeper understanding of the risk-sharing role of trade credit, that is, trade credit enhances supply chain efficiency by allowing the retailer to partially share the demand risk with the supplier. Within this role, in equilibrium, trade credit is an indispensable external source for inventory financing, even when the supplier is at a clearly disadvantageous position in managing default than a bank. Specifically, the equilibrium trade credit contract is net terms when the retailer's financial status is relatively strong. Accordingly, trade credit is the only external source the retailer uses to finance inventory. By contrast, if the retailer's cash level is low, the supplier offers two-part terms, inducing the retailer to finance inventory with a portfolio of trade credit and bank loans. Further, a deeper early-payment discount is offered when the the supplier is relatively less efficient in recovering defaulted trade credit, or the retailer has stronger market power. Trade credit allows the supplier to take advantage of the retailer's financial weakness, yet it may also benefit both parties when retailer's cash is reasonably high. Finally, using a sample of firm-level data on US-based retailers, we empirically observe the inventory financing pattern that is consistent with what our model predicts.