Credit Ratings and Short‐term Debt Financing: An Empirical Analysis of Listed Firms in Korea

• Author: Young Sang Kim,In‐Deok Hwang,Byung‐Uk Chong
• Published date: 01 February 2015
• Date: 01 February 2015
• DOI: http://doi.org/10.1111/ajfs.12083

Credit Ratings and Short-term Debt

Financing: An Empirical Analysis of Listed

Firms in Korea*

Byung-Uk Chong

College of Business Administration, University of Seoul

In-Deok Hwang**

Korea Ratings Corporation

Young Sang Kim***

Haile/United States Bank College of Business, Northern Kentucky University

Received 17 September 2014; Accepted 26 December 2014

Abstract

This paper investigates how credit ratings affect trade credit use in short-term debt financing.

According to the empirical results, under information asymmetry in the debt market, credit rat-

ings play a key role both asa screening device for the lender and as a signaling device for the bor-

rower. That is, the credit rating system can mitigate the problem of information asymmetry to

improve efficiency in the allocation of funds in Korea’s short-term debt market. Noteworthy is

that, accordingto the empirical results, there is a nonlinear relationshipbetween the level of credit

ratings and trade credit use. Among firms with low-ratings, an increase in credit ratings reduces

trade credit use in Korea, whereas among those with high ratings, an increase in credit ratings

increases trade credit use. Given that large firms have high credit ratings in Korea, the positive

relationshipbetween the level of credit ratingsand trade credit use suggests thepossibility of pred-

atory trade credittransactions. In addition, variouscharacteristics of borrowing firms,such as size,

financial distress, product characteristics, and industry characteristics, are key determinants of

trade credit usein short-term debt financing.

Keywords Asymmetric information; Credit rating; Financial distress; Trade credit; Short-term

Debt Financing

JEL Classification: G14, G24, G28, G32

*Credit rating dataare from Korea Ratings Corp., Korea InvestorsService Inc, and NICE Investors

Service Co., Ltd., and financial data on listed firms in Korea are from Korea Ratings Corp. The

authors are gratefulto the Korean Securities Associationfor its financial support for participation

in the 9th International Conference on Asia-Pacific FinancialMarkets (Decem ber 2014).

**First author.

***Corresponding author: Young Sang Kim, Haile/US Bank College of Business, Northern

Kentucky University. Tel: +1-859-572-5160, Fax: +1-859-572-6177, email: kimy1@nku.edu.

Asia-Pacific Journal of Financial Studies (2015) 44, 88–128 doi:10.1111/ajfs.12083

88 ©2015 Korean Securities Association

1. Introduction

This paper examines various determinants of trade credit use in firms’ short-term

financing and provides policy implications for the diversification of short-term

financing structures because trade credit is a nonmarket-based bilateral debt con-

tract in comparison to a bank revolving line of credit and commercial paper (CP),

both of which are market-based short-term financing instruments. In particular, this

paper provides evidence that the credit rating system can function as a mechanism

for mitigating the problem of information asymmetry such that informationally

opaque firms, such as small and medium-sized enterprises (SMEs), can expand the

use of market-based short-term financing instruments, such as a bank revolving line

of credit and CP as substitutes in trade credit use. The extension of credit rating

coverage to more informationally opaque firms can establish a mechanism through

which they can more efficiently select short-term financing instruments that corre-

spond to their own risks. Therefore, the credit rating system can restrain excessive

limitations on financial services to high-risk borrowing firms, vitalizing their busi-

ness activities. Firms need to purchase intermediate goods to produce final products

and services, and to purchase intermediate goods, they may use their own liquidity

or seek short-term debt. In short-term debt markets, there are alternative financing

instruments with different economic and financial characteristics and these can be

classified into three major types: a bank revolving line of credit, CP, and trade

credit. Trade credit is offered by suppliers in the form of postponed payment when

selling their products to buyers.

1

Trade credit is a nonmarket-based bilateral debt

contract between buyers and sellers and requires higher debt costs than a bank

revolving line of credit and CP, both of which are market-based financing instru-

ments. In well-developed financial markets of industrialized countries such as the

United States and those in Western Europe, trade credit is widely used among

high-risk firms. In Korea, trade credit is also widely used for short-term financing,

together with a bank revolving line of credit and CP.

2

Because the credit rating sys-

tem provides information on a firm’s future cash flow and risk and thus reflects the

firm’s intrinsic value, it can mitigate the problem of information asymmetry and

improve the efficiency of financial markets. In addition, because credit ratings may

be a device through which a borrowing firm can signal the type of its own risk, it

can help the borrowing firm select an efficient structure of short-term debt financ-

ing to fit its own risk. In particular, given that SMEs are more likely to have the

problem of information asymmetry than large firms, the expansion of credit ratings

1

Trade credit is also generally known as accounts payable and is a bilateral debt contract

between nonfinancial companies. Its key characteristic is that it is a short-term financing

option in the form of deferred payment and is operated through credit transaction accounts.

2

In the sample for the 2000–2012 period, the ratio of trade credit to total assets is 8.65% for

large firms (chaebol-affiliated firms: 9.76%), and for small firms 8.28%. In terms of the debt

ratio, the short-term bank loan ratio is 13.97% for large firms (chaebol-affiliated firms:

9.13%), and for small firms 15.59%.

Credit Rating and Short-term Debt Financing

©2015 Korean Securities Association 89

across SMEs can help minimize distortion in selecting a short-term financing struc-

ture.

This paper investigates whether credit ratings play a role as a screening device

for lenders as well as a signaling device for a borrower when there is information

asymmetry. In particular, this paper focuses on the effects of the credit rating sys-

tem on the use of trade credit based on alternative (but not perfectly substituting)

short-term financing sources, such as a bank revolving line of credit, CP, and trade

credit. An empirical analysis examines various determinants of firms’ trade credit

use, and control variables for firms’ financial and operational characteristics are

included for estimation purposes. Because many economic factors, such as a dichot-

omy between large firms and SMEs, the concentration of economic power in chae-

bol-affiliated firms, and industry characteristics, affect firms’ trade credit use, effects

of these factors are estimated. Because purchasing/borrowing firms’ trade credit use

is closely related to characteristics of products and services supplied by selling and

lending firms, product/service and industry characteristics are controlled for the

estimation process.

According to the empirical results, when there is information asymmetry in the

debt market, credit ratings play a key role both as a screening device for lenders

and a signaling device for borrowers. Therefore, the credit rating system can miti-

gate the problem of information asymmetry to improve efficiency in the allocation

of funds in Korea’s short-term debt market. Noteworthy is a nonlinear relationship

between the level of credit ratings and trade credit use. Among firms with low rat-

ings, an increase in credit ratings reduces trade credit use, whereas among those

with high ratings, this increase increases trade credit use. The level of credit ratings

and that of trade credit use have a nonlinear and U-shaped relationship. Given that

large firms in Korea have high credit ratings, the positive relationship between the

level of credit ratings and trade credit use reflects the possibility of predatory trade

credit transactions. In addition, various characteristics of borrowing firms, including

size, financial distress, product characteristics, and industry characteristics, are key

determinants of trade credit use in short-term debt financing.

The rest of this paper is organized as follows: Section 2 provides a review of the

literature on trade credit and short-term financing. Section 3 describes short-term

debt and develops the hypotheses. Section 4 describes the data and presents the

empirical results, and Section 5 concludes with a summary.

2. Literature Review

Previous studies of trade credit use among alternative sources of short-term financ-

ing instruments can be regarded as the extension and application of traditional

research on the selection of external financing sources in corporate finance.

Research on trade credit falls into two main streams.

One stream of research focuses on “business” motives for trade credit, viewing

it as a way to minimize transaction costs (Ferris, 1981), that allows firms to practice

B.-U. Chong et al.

90 ©2015 Korean Securities Association