Exploring the impacts of trade credit financing on market equilibrium

Picture this: you are an entrepreneur with an idea for a potentially world-changing product. You’ve poured your savings into a prototype and it is garnering praise from peers and mentors. It’s time to scale. But how do you fund it? You can’t lean on friends and family. There is no angel investor ready to swoop in and save the day. One of your manufacturing contacts mentions trade credit financing. With delayed payment terms, it may seem like your only option.

Trade credit financing refers to the practice of vendors allowing your business to place and receive orders without making an immediate payment. The supplier gives the buyer a fixed period of time to make the payment, typically somewhere between 30 and 90 days. Although trade credit financing is a popular and convenient source of short-term financing to grow businesses, the financial tool is being abused in some cases.

Victor Song, assistant professor in finance, innovation and entrepreneurship at SFU Beedie, co-authored an article in The Review of Financial Studies discussing the potential for abuse through trade credit financing. In the wrong circumstances, it can be used to fix prices and distort the product market.

Trade credit: Advantages and disadvantages

The immediate appeal to business owners is clear: it is incredibly easy to arrange, in contrast with bank financing. It is cheap and business owners can retain control and ownership of their business. It also allows retailers to build relationships with their suppliers. Little wonder that it is a common short-term source of financing for new and start-up businesses, comprising up to 50 per cent of total short-term debt for U.S. and British-representative firms.

Dig a little deeper, however, and you’ll discover trade credit also has some disadvantages. There is product risk and the potential for quality disputes, as well as manufacturing risk. There’s also transportation risk that can be mitigated through insurance and reliable freight shipping. Currency risk can also impact trade credit with exchange rate uncertainty affecting profit margins. The complexity of trade financing agreements itself can be a barrier in many cases for unfamiliar users.

The chief concern, however, is that trade financing influences product market competition because of the structure of interest payments and conditions of the agreement. Under a trade credit agreement, customers borrow goods from their suppliers free of charge for a defined period and must pay an extremely high interest rate, set by the supplier, should they need to extend their financing.

This is not a problem when demand for the product is high, and the customer can sell their whole inventory within the free financing period. However, when demand is low, the trade credit penalty rate at which leftover inventory must be financed will shape the retailer’s behavior in the product market. As such, suppliers and manufacturers have the potential to collude through manipulation of the supply and demand. When demand is high, constrained inventory will drive prices higher, which ultimately impacts the end-consumer.

Trade credit is less useful as a collusion mechanism when the bargaining power of the retailer is high. Increased producer surplus can only happen when all the suppliers in an industry collude to promote trade credit. When retailers have the flexibility to pay with set aside cash, they can avoid incurring penalty fees by paying off trade credit obligations in good time.

Shaping future discussions in banking and commerce

Song and his contemporaries offer a novel explanation on why trade credit persists despite its drawbacks. By comparing banking financing and trade credit and the impact they have on different industries, company size and market conditions, they argue that trade credit plays a significant role in shaping the inventory policies and market strategies for retailers in uncertain markets.

The distortions that trade credit financing introduces to product markets allow suppliers to increase their profits at the expense of consumer surplus, and, in some market conditions, trade credit can be used as mechanism to fix prices and mitigate competition.

The findings of this work also have important policy implications for industries that rely heavily on vendor financing and help contribute to the larger discussions around how the separation of banking and commerce could help shut down potential collusion among suppliers.