Downstream Value of Upstream Finance

• Date: 01 November 2013
• Published date: 01 November 2013
• DOI: http://doi.org/10.1111/fire.12021

The Financial Review 48 (2013) 697–723

Downstream Value of Upstream Finance

Matthew D. Hill∗

University of Mississippi

G. Wayne Kelly

University of Southern Mississippi

G. Brandon Lockhart

Clemson University

Abstract

We examine market value implications of managing liquidity via supplier financing.

Results suggest a direct link between shareholder wealth and use of trade credit, and the

relation exhibits significant cross-sectional variation. In particular, the market value of trade

credit varies with the liquidity of goods sold and competition in product markets. Evidence

also indicates the value-supplier financing association strengthens with financial constraint,

which supports the financing motive for trade credit. Further findings are consistent with the

transaction cost motive. Overall, we conclude that shareholders value the strategic benefits

associated with supplier financing and that downstream firms’ characteristics influence this

value.

Keywords: trade credit, working capital, corporate liquidity

JEL Classifications: G30, G32

∗Corresponding author: Department of Finance, University of Mississippi, 227 Holman Hall, University,

MS 38677; Phone: (662) 915-5101; Fax: (662) 915-5821; E-mail: mhill@bus.olemiss.edu.

This research was conducted while Lockhart was an Assistant Professor of Finance at the University

of Nebraska-Lincoln. We thank Ken French for providing portfolio breakpoints and returns data via his

website at Dartmouth University. We thank Richard DeFusco, Robert Van Ness (editor), two anonymous

referees, Vinod Venkiteshwaran (discussant, 2011 FMA Annual Meeting), and Larry White for their

comments. All errors remain sole responsibility of the authors.

C2013 The Eastern Finance Association 697

698 M. D. Hill et al./The Financial Review 48 (2013) 697–723

1. Introduction

Corporate liquidity policy is irrelevant if capital markets function perfectly.

However, frictions such as agency problems, differential tax rates among corpora-

tions and investors, and information asymmetries can result in value implications

from managing liquidity. Managers of firms facing these frictions might desire fi-

nancial flexibility to avoid the underinvestment problem caused by credit rationing

or prohibitive transaction costs from accessing capital markets (Gamba and Triantis,

2008). Recent research suggests shareholders value liquidity management via cor-

porate cash holdings and credit lines (Faulkender and Wang, 2006; Flannery and

Lockhart, 2009; Denis and Sibilikov, 2010).

Despite these studies, little is known about cross-sectional differences in share-

holders’ valuation of supplier-provided liquidity.1We explore this topic by studying

the relation between excess stock returns and the use of trade credit by downstream

firms (i.e., buyers).

The integral role of trade credit in a firm’s daily operations warrants a better un-

derstanding of the influence of supplier financing on shareholder wealth. This form of

financing provides immediate acquisition of inputs on delayed payment terms, giving

cash-constrained buyers time to sell their products and repay the trade credit from the

proceeds. Absent supplier financing, buyers with significantfinancing frictions might

underinvest in capital goods necessary to their production processes.2The economi-

cally large volume of trade credit outstanding on firms’ balance sheets also motivates

the present study. Despite that the typical level of payables is comparable in size to

cash holdings, studies examining firm value implications of liquidity management

focus primarily on cash.

Our results provide robust evidence of a direct and significant relation between

excess returns and use of supplier financing, indicating the flexibility provided by

trade credit systematically increases equity values. This relation supports positive

aspects of supplier financing, including improved liquidity and present value savings.

Baseline estimates indicate the market values an additional $1 of trade payables at

$0.15, which is substantially smaller than typical estimates for the marginal value of

cash (Faulkender and Wang, 2006). This difference is consistent with theory since

1Hill, Kelly and Lockhart (2012) study the shareholder wealth effects of upstream firms’ extension of

trade credit, thereby focusing on trade credit from the supplier’s perspective. Aktas, de Bodt, Lobez and

Statnik (2012) find some evidence of a positive correlation between the quality of firms’ investmentsand

use of trade credit. This study differs from ours in three ways: First, while we focus exclusivelyon excess

returns, most of their models use Altman’s Z-score to proxy investment quality. Second, the samples

used by Aktas, de Bodt, Lobez and Statnik (2012) consist of firms with Z-scores higher than the median;

this may be problematic as lower credit quality firms likely have the greatest need for trade credit. Last,

we primarily focus on cross-sectional variation in the market value of payables, which allows us to test

whether shareholders acknowledge the theoretical determinants of trade credit use.

2At the extreme, reductions in trade credit can force customers into bankruptcy.Anecdotal evidence from

the recent plight of Borders Group, Inc. supports this conjecture. Ultimately, the firm was forced into

bankruptcy as suppliers would no longer extend trade credit because of increased default risk.