Financing seasonal demand

• DOI: http://doi.org/10.1111/fima.12290
• Author: Douglas (DJ) Fairhurst
• Date: 01 September 2020
• Published date: 01 September 2020

DOI: 10.1111/fima.12290

ORIGINAL ARTICLE

Financing seasonal demand

Douglas (DJ) Fairhurst

Department of Finance and Management

Science, WashingtonState University, Pullman,

Washin gton

Correspondence

Douglas(DJ) Fairhurst, Department of Finance

andManagement Science, Washington State

University,300 NE College Avenue,Pullman, WA

99663.

Email:dj.fairhurst@wsu.edu

Abstract

This paper identifies seasonal firms and their peak seasons to pro-

vide empirical evidence of the approach these firms take to finance

seasonal operations. The seasonal use of funds, which builds before

seasonal revenue, is largely financed with transitory sources of

credit, such as credit lines, trade credit, and commercial paper. Per-

manent financing is used only moderately to meet seasonal needs.

However, both weak credit market conditions and firm-levelfinan-

cial constraints limit the ability of seasonal firms to use debt as tran-

sitory financing. These frictions result in a partial shift to permanent

financing but reduce the seasonal use of funds overall.

1INTRODUCTION

Significant evidence shows how investment needs affect firms’ long-term financial policies such as leverage,the level

of cash holdings, and the composition of payout to shareholders based on growth opportunities (see DeAngelo, DeAn-

gelo, & Whited, 2011; Denis & McKeon, 2012; Jagannathan, Stephens, & Weisbach, 2000; Opler,Pinkowitz, Stulz, &

Williamson, 1999; for related survey studies, see Almeida, Campello, Cunha, & Weisbach, 2014; Denis, 2011). Less

evidence exists on how firms manage short-term financing needs. Seasonal firms emphasize short-term financial poli-

cies. Seasonal managers must decide whether to meet seasonal needs with either a transitory or permanent financing

approach. In this paper, I provideempirical evidence of the approach taken by seasonal firms and how capital market

frictions affect this approach.

Surprisingly, we have little empirical evidence about the financing choices of seasonal firms, which account for a

notable fraction of the economy. Managers of seasonal firms frequently discuss the risk inherent in using financing

to prepare for seasonal needs before receiving a clear signal of the economic environment. For example, AeroGrow

International, Inc. discussed this risk in their 2016 10-K:

[A]pproximately65.7% of our total net sales occurred during four consecutive calendar months (October through

January). Wemust therefore estimate sales in advance of the anticipated peak months and operate our business

during the balance of the year in such a way as to insure that we can meet the demand for our products during

c

2019 Financial Management Association International

Financial Management. 2020;49:839–870. wileyonlinelibrary.com/journal/fima 839

840 FAIRHURST

the peak months. This requires us…to utilize cash and other capital resources to invest in inventory in advance

of having certainty as to the ultimate level of demand for our product during the peak months.1

Theoretically,it is unclear how managers finance seasonal needs. At one extreme, managers may take a permanent

approachto finance these needs. Specifically, a manager may raise enough long-term capital and/orretain enough earn-

ings to finance operations in periods when seasonal needs are at their highest expected level. Cash reservesare then

used to finance peak seasons. Subsequently,as cash flow is generated from operations, excess cash is held until needs

increase again. Managers may prefer this approach for a few reasons. First, permanent financing alleviates concerns

from risk-averse managers that financing will not be available from the capital markets when needed, such as when

capital marketfrictions are high. Second, this approach avoids trips to the capital markets. As such, managers may opti-

mize economies of scale because fixed costs are an important part of issuance costs (Altinkiliç & Hansen, 2000). How-

ever,the use of permanent funds relies on excess cash, which can be costly because these assets generate low returns

and expose firms to agency costs.

Alternatively,managers may rely on transitory financing to meet seasonal needs by accessing financing when needs

increase and then paying down the balances when needs are low. Despite exposing managers to the risk of financ-

ing availability, managers may prefer this approach for severalreasons. First, transitory financing typically comes in

the form of private credit. Private credit minimizes costs of external financing stemming from information asymmetry,

as lenders receive private signals of borrower quality (Bernanke, 1983; Fama, 1985; James, 1987). Furthermore, pri-

vate credit is typically short term. As such, this approach matches the maturities of assets and liabilities, an apparent

preference of managers (Myers, 1977). Second, short-term rates are typically lower than long-term rates. Transitory

financing avoids payingthe term premium when the funds are not in use. Finally, this approach avoids costs associated

with excesscash.

Todiscriminate between these financing approaches, I establish a methodology to identify seasonal firms and sea-

sonal fluctuations in their use of funds.2I use the Compustat Quarterly Fundamentals file from 1984 to 2016 and test

for differences in average revenue across the four fiscal quarters for each firm. A firm with significant differences in

revenue across its fiscal quarters is classified as seasonal. For seasonal firms, the peak quarter is defined as the fis-

cal quarter with the highest mean revenue, and the other three quarters are defined relative to the peak. About 22%

of sample firm quarters are classified as seasonal. For robustness, I use two additional, related seasonal classification

approaches. One model includes a time trend to ensure that growing or shrinking firms are not falsely classified as

seasonal. The other uses only historical data.

Several tests support the validity of the proxy.For instance, firms classified as seasonal appear in many industries

but cluster in industries typically thought to be seasonal such as retail and apparel (63.5% and 63.1% of firms, respec-

tively).3Also, these firms use the word “seasonal” more than three times as often in their 10-K filings, are four times

more likelyto display seasonality in Google search interest, and are 77.0% more likely to report that they rely substan-

tially on seasonal or part-time employees than other firms.

Next, I test for seasonal fluctuations in the use of funds. Consistent with the AeroGrow anecdote provided earlier,

the results show that the use of funds increases in the quarter before the peak quarter (hereafter,the prepeak period),

remainhigh through the peak quarter, and then decline in the next two quarters. These funds are used to build up inven-

tory and fund accounts receivable; selling, general, and administrative expenditures;and some capital expenditures. I

next consider how firms finance seasonal fluctuations in the use of funds.

First, I consider whether firms use a transitory financing approach and find that they do. Debt balances of seasonal

firms increase by 5.7% relative to the mean in the prepeak quarter and remain high in the peak quarter.Debt balances

1See:https://www.sec.gov/Archives/edgar/data/1316644/000118518517001448/aerogrow10k033117.htm.

2Pleasecontact the author for data classifying Compustat firms as either seasonal or nonseasonal as well as the identified peak quarter for seasonal firms.

3Although the retail and apparel industries consist of the highest proportion of seasonal firms, the seasonal financing patterns presented in this paper are

robustto excluding either of these industries.

FAIRHURST 841

then decline following the receipt of seasonal revenues, mirroring the pattern in the seasonal use of funds. This evi-

dence suggests that transitory debt is an important source of financing for seasonal firms.

Second, I consider whether seasonal firms use private credit as a source of transitory financing. I find that seasonal

firms are more likely to havea line of credit, an important source of private credit for liquidity management. I also find

thatthe use of debt is less apparent for seasonal firms that have access to commercial paper, which typically has shorter

maturity.The use of debt, especially private debt, to meet seasonal financing needs suggests that firms at least partially

finance seasonal fluctuations using transitory financing.

Trade credit is another potential source of transitoryfinancing. Trade credit and private debt share many advan-

tages. For instance, both avoid the costs of holding excess cash. Furthermore, trade credit reduces information

asymmetry costs as suppliers receive signals about borrower quality through their operational relationships with

customer firms (Biais & Gollier, 1997; Petersen & Rajan, 1997). I find that trade credit is also a keysource of short-

term financing for seasonal firms. Trade credit balances increase by 12.2% (7.8%) in the prepeak (peak) quarter and

decline in the postpeak quarter. These findings highlight the benefits of transitory financing in meeting seasonal

needs.

Evidence of using transitory financing to meet seasonal needs does not imply that firms do not also rely on per-

manent financing. Managers may take a blended approach and use both permanent and transitory financing. I find

evidence that seasonal firms rely on permanent financing to meet seasonal needs, but to a lesser extent than tran-

sitory financing. Cash balances reduce significantly in the prepeak period and then increase following the receipt of

seasonal revenue.Yet, the magnitude of the decrease in cash holdings is one-third (less than one-half) of the magnitude

of the increase in debt (accounts payable),suggesting that transitory sources provide the majority of funds for seasonal

needs.

Tothis point, the evidence suggests that seasonal firms primarily use transitory financing to meet seasonal needs,

but this mayvary with the ability of firms to access external markets. I find that the tendency to use transitory financing

is affected bycredit market frictions, such as credit market conditions or financial constraints. Following previous work

(Harford, 2005; Harford, Klasa, & Maxwell, 2014; Officer, 2007), I proxy for credit marketconditions using the four-

quarter moving averageof the spread between the rate on commercial and industrial loans and the federal funds rate.

I find that the use of transitory debt before the peak season for seasonal firms is significantly reduced in weak credit

market conditions. Specifically,the increase in debt before the peak season is approximately 50% smaller when credit

market conditions are weak.

The reduction in the use of transitory debt is offset by the use of permanent financing because the reliance on cash

balances is significantly greater when external credit market conditions are weak. However,the use of cash only par-

tially replaces outside debt financing in weak credit marketconditions. Specifically, the decrease in cash offsets approx-

imately one-fourth of the reduced use of debt during these periods. Furthermore, the seasonal use of funds is signif-

icantly smaller in weak credit market conditions. In sum, weak credit market conditions reduce the ability of firms to

use debt to finance seasonal needs, and permanent cash balances only partially replace these funds.

Firm-level financial constraintsalso affect seasonal financing in a way that mirrors the effect of weak credit market

conditions. Specifically,financially constrained seasonal firms demonstrate a smaller increase in debt balances before

the peak season and use less funds during this period than unconstrained seasonal firms. This pattern holds using the

size–age index (Hadlock & Pierce, 2010) or the text-basedindex (Hoberg & Maksimovic, 2015), which identifies firms

constrained specifically from debt markets.

Toprovide exogenousevidence of the impact of costly access to external markets, I consider three nearly concurrent

events in 1989 as a shock to the supply of capital (see Lemmon & Roberts, 2010). This shock uniquely affected firms

withnoninvestment-grade debt. Following this shock, I find that noninvestment-grade firms used significantly less debt

before the peak season. Consistent with previous findings, some of the reduction in debt is offset with cash balances,

but the seasonal use of funds is also reduced. These patterns are not found for a matched sample of unrated seasonal

firms. Collectively,the evidence suggests that financial constraints limit the ability of seasonal firms to turn to the debt

markets and that this results in lower seasonal investment.