Why Are Trade Credits so Damn Expensive? It's a Commitment Problem

Abstract

Trade credits represent an important source of financing for all corporations. Rajan and Zingales (1995) report that account payable represent on average 14% of the book value of assets of G7 firms, which is comprised mostly of trade credits. Given that debt financing represents almost 40% of the book value of assets, it can be estimated that close to 40% of debt financing occurs through the use of trade credits. Trade credits are a very expensive form of debt financing; for instance traditional 2-10 net 30 contracts (a 2% discount if paid within 10 days, otherwise all is due in 30 days) represents an equivalent 45% annual interest rates. The goal of this paper is to present a new theory as to why trade credits are so expensive compared to bank financing and why trade credits are such important sources of financing. The theory is that non-financial firms are unable to commit credibly to an auditing strategy when the borrowing firm declares bankruptcy. In a world where entrepreneurs have private information as to the state of the world, we show that being unable to commit to verifying the true state of the world generate a higher interest rate on the loan than if the creditor could commit. We suggest that banks and financial institutions have a comparable advantage in credibly signal their ability to commit to auditing a firm who declares bankruptcy. But because it can happen that bank financing is restricted, firms need to finance their project elsewhere, from lenders that are less able to manage this commitment problem.