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How Trade Credit Can Lead to Corporate Bankruptcy

Managing accounts payable is one of the keys to liquidity and great cash flow. It also seems to be highly associated with the risk of bankruptcy according to a new study in Econometrica.

The authors looked at the impact of trade credit and bankruptcy. Trade credit is the financing that companies provide to their customers when they offer credit terms. So by offering a payment term of 30 days a company is in effect funding their customer’s business with a short term loan. On the books this is recorded as accounts payable but it is a loan.

Looking back to the  2008 financial crisis, one of the problems that was faced was the drying up of bank credit in the economic system. This happened as banks faced a liquidity crisis of their own and needed to conserve cash. This had a serious impact on businesses ability to function – seen even more clearly in 2015 in Greece.

However short term bank lending is relatively small compared to trade credit. Data for the US shows that the average amount of accounts payable that a company has on its books is about 15% of total assets. In contrast short term bank lending is only about 7% of total asset value.

We know that when lending by banks stops firms go bankrupt and when debt ratios soar that banks are in trouble. Do you get the same effect in firms and how systemic a threat is it?

Intuitively it seems pretty reasonable to say that you will get problems. You can consider it to be like a chain of dominos. As one firm goes into financial distress the losses at the firm supplying the trade credit can in turn force it into bankruptcy and so on until you reach a company with an asset base or cash reserves large enough to absorb the loss.

However no one had managed to test this intuition empirically until now. The Swedish authors looked at two data sets. The first was the financial statements of every company in Sweden over an eighteen year period. The second was the records of every bankruptcy in the same time period showing the date, the creditors and debtors of the bankruptcy firm and the amount involved.

They then combined them to get a picture if what actually happened when a company went bankrupt, and the effect of the company and all the other companies linked to it by a chain of trade credit.

With a lot of analysis the results were pretty much as expected. If you offer a lot of trade credit you can expect to lose lots of money. Part of this is because 9% of companies can expect to have at least one customer go bankrupt each year. So by offering more trade credit you increase that rusk. This seems to work along two dimensions – the total amount outstanding and the total amount to any individual customer.

The main finding was that offering large amounts of trade credit doubles you risk of bankruptcy – not just losses as customers go bankrupt. The ‘normal’ rate of bankruptcy is about 2% a year. This rises with issuance of trade credit to approximately 4%.

This risk is driven by the credit losses following the debtor failure. The researchers tested this a number of ways to see if there was any other explanation. They especially focused on the idea that a shock that hit a sector could be responsible for all the bankruptcies. Demand shocks – think of the impact of the falling oil price on the demand for oil rigs – had an impact but the vast majority of the impacts were due to the credit losses.

These came in two forms. First there was balance sheet insolvency which hit highly leveraged firms. With limited assets even a small loss made them highly vulnerable to bankruptcy. The other form was the liquidity shock and firms went bankrupt because they no longer had sufficient cash flow to meet their obligations.

There are a couple of major takeaways. First if you run a firm the ‘secrets’ to avoiding bankruptcy due to trade debtor are:

  • Reduce leverage
  • Be cash rich
  • Be highly profitable
  • Produce standardized goods

It would also be worth considering whether there are long credit chains in the sector – such that the actual real risk is hidden down the chain. One mitigation method of protecting your company, if you are vulnerable, is to hide upstream, of someone who is not.

On the macro level it seems that companies are not as good as managing credit risk as banks (and other financial firms) as their losses on credit extended run at twice the level of banks (though the authors didn’t indicate whether this is relative or absolute – given that intra firm lending was at twice the rate of bank lending).

The interlinked nature of firms also holds the possibility of multiple linked bankruptcies hitting sectors badly as was seen in the Swedish financial crisis of 1992. This leads the authors to speculate that there may be a case for designing policies that could support weak firms during a crisis to prevent greater economic damage.