Managerial ability and trade credit

• Published date: 01 May 2022
• Author: Joye Khoo,Adrian (Wai Kong) Cheung
• Date: 01 May 2022
• DOI: http://doi.org/10.1111/fire.12289

DOI: 10.1111/fire.12289

ORIGINAL ARTICLE

Managerial ability and trade credit

Joye Khoo1Adrian (Wai Kong)Cheung2

1The School of Accounting, Economics and

Finance, Curtin University,Bentley, Western

Australia,Australia

2Faculty of Finance, City University of Macau,

Taipa,Macao

Correspondence

AdrianCheung, Faculty of Finance, City Uni-

versityof Macau, Taipa,Macao.

Email:adriancheung@cityu.mo

Abstract

We examine whether and how managerial ability affects

trade credit (accounts payable, in particular). The empiri-

cal analyses show that firms with higher managerial ability

are associated with an increase in trade credit received. We

also find that the impact of managerial ability on accounts

payable is stronger for firms having poorer credit quality or

more binding financial constraints.Our findings are robust to

alternative measures of key variables, financial crises, prod-

uct characteristics, and endogeneity concerns.

KEYWORDS

managerial ability, trade credit

JEL CLASSIFICATION

G23, G32

1INTRODUCTION

Firm managers acquire ability throughout their careers by exploiting potential opportunities to developfirms’ strate-

gies and operational effectiveness, both of which play a vital role in corporate investingand financing decisions. The

significant role of managerial ability in firm decisions has received growing attention because of its importance to

future firm performance (Demerjian et al., 2020), earnings quality (Demerjian et al., 2013), credit rating (Bonsall et al.,

2017), and corporate investment opportunity (Lee et al., 2018). Prior studies show that high-ability managers have

a better understanding of their firms’ operating environment (Demerjian et al., 2012) and are less subject to career

concerns (Ali et al., 2019). These characteristics are, thus, expected to allow them to make better investment deci-

sions that are beneficial to the firm and that bolster managers’ reputations to stakeholders.Put differently, high-ability

managers are more inclined to use their superior skills to pursue valuable opportunities (Mishra, 2020)comparedwith

lesser ability managers.

This paper aims to examine whether and how managerial ability affects corporate tradecredit. 1Trade credit is an

important attribute of the short-term liquidity (between the firm and its trading partner) that has received substan-

tial attention. In general, firms rely on trade credit for purposes such as inventorypurchases and unexpected financial

1Inthis paper, we use the terms trade credit and accounts payable interchangeably.

Financial Review. 2022;57:429–451. wileyonlinelibrary.com/journal/fire ©2021 The Eastern Finance Association 429

430 KHOO AND CHEUNG

needs (Yang& Birge, 2018). Jory et al. (2020) retrieve data from the US flow of funds account and highlight an increase

of 434% in accounts payable between the years 1985 and 2017. Ample studies, such as Hill et al. (2012), Molina and

Preve (2009), and others, document that trade credit is positively associated with firms’ operating and financial per-

formance, stock returns, and industry growth.

Most studies focus on examining firm-specific influences on trade credit policy,and investigation of the impact of

managerial ability and skills is limited. Towhat extent the ability of managers’ and suppliers’ response to it influence

firms’ use of trade credit is an interesting question that remains largely unexplored. Motivated by the literature on

managerial ability and trade credit, we develop three hypotheses that might relate managerial ability to firms’ trade

credit. Existing studies document that high-ability managers possess a better understanding of technology and indus-

try trends, are more proactive toward future changes than their peers, and manage risk better (Demerjian et al., 2012;

Trueman,1986). Because of their superior ability, higher-ability managers appear to implement their chosen strategies

effectively—for example,they generate higher corporate earnings quality (Demerjian et al., 2013) and enhance future

operating performance (Demerjian et al., 2020) which, in turn, benefits stakeholders as well as bolster the managers’

reputation.

Considering the importance of trade credit, a fundamental source of liquidity for firms, coupled with the signifi-

cant role of managerial ability in firm decisions, we propose that because of their superior ability and skills, customer

firms with high-ability managers are likely to have more trade credit (accounts payable)extended by their suppliers.

When extending tradecredit to their customers, suppliers’ cash receipts and liquidity are negatively affected and also

directly impact their capacity to offer trade credit to other customers. From customers’ point of view, when receiving

trade credit granted by suppliers, short-term liquidity is ameliorated as they can preservecash; however, short-term

liability increases concurrently.Meeting accounts payable obligations could become more challenging when having a

great amount of trade credit outstanding. As such, customer firms could face potential ratings downgrades and diffi-

culty in obtaining capital from external markers.2Thus, it is interesting and important to understand the role of man-

agerial ability in determining trade credit. All else being equal, managerial ability is viewed as an important corporate

asset that is beneficial to the shareholders, likely to be better trusted by stakeholders(especially suppliers), and thus

increases the capacity of firms to obtain credit from suppliers.

The positive effect of managerial ability should be particularly relevantfor firms with poorer credit quality because

these firms are expected to have greater demand for trade credit and to gain greater financial flexibility. That is, a

poorer (better) credit rating is associated with a higher (lower) refinancing risk which, in turn, heightens the impor-

tance of accounts payable for firms with poorer credit quality. Under this view,the second hypothesis posits that in

the presence of poorer credit ratings, firms with high-ability managers are likelyto obtain more trade credit from their

suppliers. The third hypothesis is concerned with firms’ financial health. For financially constrained firms, accounts

payable is an important source of external funding that may ease their financial burden in the short term, suggesting

that their reliance on trade credit financing is stronger than it would be for financially unconstrained firms. Thus, this

hypothesis predicts that financially constrained firms operatedby high-ability managers are likely to hold more trade

credit from their suppliers.

Our sample includes 124,282 firm-year observations (12,612 unique firms) from the Center for Research in Secu-

rity (CRSP)/Compustatmerged data set over the period 1981–2016. Using Demerjian et al.’s (2012) managerial ability

measure, we find that high-ability managers are positively associated with firms’ use of accounts payable. These are

consistent with the notion that suppliers are receptive to the presence of superior managerial ability,which is viewed

as a corporate asset and, thus, are more willing to extend credit to customer firms with high-ability managers. The

results obtained from cross-sectional analyses suggest that the positiverelation can be moderated by credit rating and

financial constraint. In particular,we find that high-ability managers also rely more (less) on accounts payable for firms

with poor (better) credit quality.In addition, the positive relation between managerial ability and accounts payable is

more pronounced for financially constrained firms, consistent with our expectation that financial constraint signals

2Wewould like to thank the reviewer for the suggestion of presenting a more balanced and nuanced view.